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Rule

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”

Action

Joint Final Rule; Joint Interim Final Rule; Interpretations.

Summary

In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, the “Commissions”), in consultation with the Board of Governors of the Federal Reserve System (“Board”), are adopting new rules and interpretive guidance under the Commodity Exchange Act (“CEA”), and the Securities Exchange Act of 1934 (“Exchange Act”), to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.”

Unified Agenda

Further Definitions of Swap Dealer, Major Swap Participant, and Eligible Contract Participant

8 actions from August 13th, 2010 to December 2011

  • August 13th, 2010
  • September 20th, 2010
    • ANPRM Comment Period End
  • December 21st, 2010
  • February 22nd, 2011
    • NPRM Comment Period End
  • May 4th, 2011
  • June 3rd, 2011
    • NPRM Comment Period Extended End
  • June 6th, 2011
  • December 2011
    • Final Action

Definitions Contained in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act

8 actions from August 20th, 2010 to December 2011

  • August 20th, 2010
  • September 20th, 2010
    • ANPRM Comment Period End
  • December 21st, 2010
  • February 22nd, 2011
    • NPRM #1 Comment Period End
  • May 23rd, 2011
  • July 22nd, 2011
    • NPRM #2 Comment Period End
  • December 2011
    • Final Action #1
  • December 2011
    • Final Action #2
 

Table of Contents Back to Top

Tables Back to Top

DATES: Back to Top

Effective date. The effective date for this joint final rule and joint interim final rule: July 23, 2012, except for CFTC regulations at 17 CFR 1.3(m)(5) and (6), which are effective December 31, 2012.

Comment date. The comment period for the interim final rule (CFTC regulation at 17 CFR 1.3(ggg)(6)(iii)) will close July 23, 2012.

Compliance date. Compliance with the element of the CFTC regulation at 17 CFR 1.3(m)(8)(iii) requiring that a commodity pool be formed by a registered CPO shall be required with respect to a commodity pool formed on or after December 31, 2012 for any person seeking to rely on such regulation; compliance with such element shall not be required with respect to a commodity pool formed prior to December 31, 2012.

FOR FURTHER INFORMATION CONTACT: Back to Top

CFTC: Jeffrey P. Burns, Assistant General Counsel, at 202- 418-5101, jburns@cftc.gov, Mark Fajfar, Assistant General Counsel, at 202-418-6636, mfajfar@cftc.gov, Julian E. Hammar, Assistant General Counsel, at 202-418-5118, jhammar@cftc.gov, or David E. Aron, Counsel, at 202-418-6621, daron@cftc.gov, Office of General Counsel; Gary Barnett, Director, at 202-418-5977, gbarnett@cftc.gov, or Frank Fisanich, Deputy Director, at 202-418-5949, ffisanich@cftc.gov, Division of Swap Dealer and Intermediary Oversight,Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581;

SEC: Joshua Kans, Senior Special Counsel, Richard Grant, Special Counsel, or Richard Gabbert, Attorney Advisor, at 202-551-5550, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: Back to Top

I. Background Back to Top

On July 21, 2010, President Obama signed the Dodd-Frank Act into law. [1] Title VII of the Dodd-Frank Act established a statutory framework to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (i) providing for the registration and regulation of swap dealers and major swap participants; (ii) imposing clearing and trade execution requirements on standardized derivative products; (iii) creating recordkeeping and real-time reporting regimes; and (iv) enhancing the Commissions' rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commissions' oversight.

The Dodd-Frank Act particularly provides that the CFTC will regulate “swaps,” and that the SEC will regulate “security-based swaps.” The Dodd-Frank Act also adds definitions of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant” to the CEA and Exchange Act. [2] Section 712(d)(1) of the Dodd-Frank Act further directs the CFTC and the SEC, in consultation with the Board, jointly to further define those terms, among others. [3]

In December 2010, the Commissions proposed rules and interpretations to further define the meaning of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” [4] The Commissions received approximately 968 written comments in response to the Proposing Release. [5] In addition, the Staffs of the Commissions participated in approximately 114 meetings with market participants and other members of the public about the Proposing Release, [6] and the Commissions held a Joint Public Roundtable on the proposed dealer and major participant definitions. [7] After considering the comments received, the Commissions are adopting final rules and interpretations to further define these terms.

II. Definitions of “Swap Dealer” and “Security-Based Swap Dealer” Back to Top

The Dodd-Frank Act definitions of the terms “swap dealer” and “security-based swap dealer” focus on whether a person engages in particular types of activities involving swaps or security-based swaps. [8] Persons that meet either of those definitions are subject to statutory requirements related to, among other things, registration, margin, capital and business conduct. [9]

The CEA and Exchange Act definitions in general encompass persons that engage in any of the following types of activity:

(i) Holding oneself out as a dealer in swaps or security-based swaps,

(ii) making a market in swaps or security-based swaps,

(iii) regularly entering into swaps or security-based swaps with counterparties as an ordinary course of business for one's own account, or

(iv) engaging in any activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps. [10]

These dealer activities are enumerated in the CEA and Exchange Act in the disjunctive, in that a person that engages in any one of these activities is a swap dealer under the CEA or security-based swap dealer under the Exchange Act, even if such person does not engage in one or more of the other identified activities.

At the same time, the statutory dealer definitions provide exceptions for a person that enters into swaps or security-based swaps for the person's own account, either individually or in a fiduciary capacity, but not as a part of a “regular business.” [11] The Dodd-Frank Act also instructs the Commissions to exempt from designation as a dealer a person that “engages in a de minimis quantity of [swap or security-based swap] dealing in connection with transactions with or on behalf of its customers.” [12] Moreover, the definition of “swap dealer” (but not the definition of “security-based swap dealer”) provides that an insured depository institution is not to 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.” [13] The statutory definitions further provide that a person may be designated as a dealer for one or more types, classes or categories of swaps or security-based swaps, or activities without being designated a dealer for other types, classes or categories or activities. [14]

In the Proposing Release, the Commissions proposed rules to identify the activity that would cause a person to be a dealer, [15] to implement the exception for de minimis dealing activity, [16] to implement the exception from the swap dealer definition in connection with the origination of loans by insured depository institutions, [17] and to provide for the limited purpose designation of dealers. [18] The release also set forth proposed interpretive guidance related to the definitions.

After considering the comments received, the Commissions are adopting final rules and interpretations to further define the terms “swap dealer” and “security-based swap dealer.” In this Adopting Release, we particularly address: (i) The general analysis for identifying dealing activity involving swaps and security-based swaps; (ii) the exclusion from the “swap dealer” definition in connection with the origination of loans by insured depository institutions; (iii) the application of the dealer analysis to inter-affiliate swaps and security-based swaps; (iv) the application of the de minimis exception from the dealer definitions; and (v) the limited designation of swap dealers and security-based swap dealers.

A. General Considerations for the Dealer Analysis

1. Proposed Approach

The proposed rules to define the activities that would lead a person to be a “swap dealer” and “security-based swap dealer” were based closely on the corresponding language of the statutory definitions. [19] The Proposing Release further noted that the Dodd-Frank Act defined the terms “swap dealer” and “security-based swap dealer” in a functional manner, and stated that those statutory definitions should not be interpreted in a constrained, overly technical or rigid manner, particularly given the diversity of the swap and security-based swap markets. The Proposing Release also identified potential distinguishing characteristics of swap dealers and security-based swap dealers based on the functional role that dealers fulfill in the swap and security-based swap markets, such as: dealers tend to accommodate demand from other parties; dealers generally are available to enter into swaps or security-based swaps to facilitate other parties' interest; dealers tend not to request that other parties propose the terms of swaps or security-based swaps, but instead tend to enter into those instruments on their own standard terms or on terms they arrange in response to other parties' interest; and dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer's own initiative. [20]

The proposal recognized that the principles for identifying dealing activity involving swaps can differ from principles for identifying dealing activity involving security-based swaps, in part due to differences in how those instruments are used. [21]

a. “Swap Dealer” Activity

Consistent with the statutory definition, the proposed rule stated that the term “swap dealer” includes a person that “regularly enters into swaps with counterparties as an ordinary course of business for its own account,” but also that “the term swap dealer does 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.” The Proposing Release stated that these two provisions should be read in combination with each other, and explained that the difference between the two provisions is whether or not the person enters into swaps as a part of, or as an ordinary course of, a “regular business.” Thus, the Proposing Release equated the phrases “ordinary course of business” and “regular business.” The Proposing Release also stated that persons who enter into swaps as a part of a “regular business” are those persons whose function is to accommodate demand for swaps from other parties and enter into swaps in response to interest expressed by other parties. Such persons would be swap dealers. [22] Conversely, the Proposing Release said that persons who do not fulfill this function in connection with swaps should not be deemed to enter into swaps as part of a “regular business,” and thus would not likely be swap dealers. [23]

In addition, the Proposing Release noted that the nature of swaps precludes importing concepts used to identify dealers in other areas. The Proposing Release explained that because swaps are typically not bought and sold, concepts such as whether a person buys and sells swaps, makes a two-sided market in swaps, or trades within a bid/offer spread cannot necessarily be used to determine if the person is a swap dealer, even if such concepts are useful in determining whether a person is a dealer in other financial instruments. [24]

The Proposing Release further stated that swap dealers can be identified through their relationships with counterparties, explaining that swap dealers tend to enter into swaps with more counterparties than do non-dealers, and in some markets, non-dealers tend to constitute a large portion of swap dealers' counterparties. In contrast, the Proposing Release said, non-dealers tend to enter into swaps with swap dealers more often than with other non-dealers. The Proposing Release noted that it is likely that swap dealers are involved in most or all significant parts of the swap markets. [25]

The Proposing Release concluded that this functional approach would identify as swap dealers those persons whose function is to serve as the points of connection in the swap markets. Thus, requiring registration and compliance with the requirements of the Dodd-Frank Act by such persons would thereby reduce risk and enhance operational standards and fair dealing in those markets. [26]

The Proposing Release also noted that the swap markets are diverse and encompass a wide variety of situations in which parties enter into swaps with each other, and invited comment as to what aspects of the parties' activities in particular situations should, or should not, be considered swap dealing activities. Specifically, the Proposing Release invited comment regarding persons who enter into swaps: (i) As aggregators; (ii) as part of their participation in physical markets; or (iii) in connection with the generation and transmission of electricity. [27]

First, regarding aggregators, the Proposing Release noted that some persons, including certain cooperatives, enter into swaps with other parties in order to aggregate the swap positions of the other parties into a size that would be more amenable to entering into swaps in the larger swap market. The Proposing Release explained that, for example, certain cooperatives enter into swaps with smaller businesses because the smaller business cannot establish a commodity position large enough to be traded on a swap or futures market, or large enough to be of interest to larger financial institutions. The Proposing Release said that while such persons engage in activities that are similar in many respects to those of a swap dealer, it may be that the swap dealing activities of these aggregators would not exceed the de minimis threshold, and therefore they would not be swap dealers. The CFTC requested comment as to how the de minimis threshold would apply to such persons, and in general on the application of the swap dealer definition to this activity. The Proposing Release also noted that the CFTC was engaged in a separate rulemaking pursuant to section 723(c)(3)(B) of the Dodd-Frank Act regarding swaps in agricultural commodities, and requested comment on the application of the swap dealer definition to dealers, including potentially agricultural cooperatives, that limit their dealing activity primarily to swaps in agricultural commodities. [28]

Second, the Proposing Release noted that the markets in physical commodities such as oil, natural gas, chemicals and metals have developed highly customized transactions, some of which would be encompassed by the statutory definition of the term “swap,” and that some participants in these markets engage in swap dealing activities that are above the proposed de minimis threshold. The CFTC invited comment as to any different or additional factors that should be considered in applying the swap dealer definition to participants in these markets.

Third, the Proposing Release noted a number of complexities that arise when applying the swap dealer definition in connection with the generation and transmission of electricity. In particular, the Proposing Release noted that additional complexity results because electricity is generated, transmitted and used on a continuous, real-time basis, and because the number and variety of participants in the electricity market is very large, and some electricity services are provided as a public good rather than for profit. The CFTC invited comment as to any different or additional factors that should be considered in applying the swap dealer definition to participants in the generation and transmission of electricity. Specifically, the CFTC invited comment on whether there are special considerations, including without limitation special considerations arising from section 201(f) of the Federal Power Act, [29] related to not-for-profit power systems such as rural electric cooperatives and entities operating as political subdivisions of a state and on the applicability of the exemptive authority in section 722(f) of the Dodd-Frank Act to address those considerations.

b. “Security-Based Swap Dealer” Activity

The Proposing Release noted the parallels between the definition of “security-based swap dealer” and the definition of “dealer” under the Exchange Act, [30] as well as the fact that security-based swaps may be used to hedge risks associated with owning certain types of securities or to gain economic exposure akin to ownership of certain types of securities. As a result, the Proposing Release took the view that the same factors that are relevant to determining whether a person is a “dealer” under the Exchange Act also are generally relevant to the analysis of whether a person is a security-based swap dealer. The Proposing Release also addressed the relevance of the “dealer-trader” distinction for identifying dealing activity involving security-based swaps, [31] while recognizing that certain concepts associated with the dealer-trader distinction—particularly concepts involving “turnover of inventory” and “regular place of business”—appeared potentially less applicable to the security-based swap dealer definition. In addition, the Proposing Release noted that under the dealer-trader distinction, we would expect that entities that use security-based swaps to hedge business risks, absent other activities, likely would not be dealers. [32]

c. Additional Principles Common to Both Definitions

i. “Hold Themselves Out” and “Commonly Known in the Trade” Tests

The Proposing Release identified the following non-exclusive list of factors as potentially indicating that a person meets the “hold themselves out” and “commonly known in the trade” tests of the statutory dealer definitions:

  • Contacting potential counterparties to solicit interest in swaps or security-based swaps;
  • Developing new types of swaps or security-based swaps (which may include financial products that contain swaps or security-based swaps) and informing potential counterparties of the availability of such swaps or security-based swaps and a willingness to enter into such swaps or security-based swaps with the potential counterparties;
  • Membership in a swap association in a category reserved for dealers;
  • Providing marketing materials (such as a Web site) that describe the types of swaps or security-based swaps that one is willing to enter into with other parties; or
  • Generally expressing a willingness to offer or provide a range of financial products that would include swaps or security-based swaps. [33]

The Proposing Release further stated that the test for being “commonly known in the trade” as a swap dealer or security-based swap dealer may appropriately reflect, among other factors, the perspective of persons with substantial experience with and knowledge of the swap and security-based swap markets (regardless of whether a particular entity is known as a dealer by persons without that experience or knowledge). The Proposing Release also stated that holding oneself out as a security-based swap dealer likely would encompass a person who is a dealer in another type of security entering into a security-based swap with a customer, as well as a person expressing its availability to enter into security-based swaps, regardless of the direction of the transaction or across a broad spectrum of risks. [34]

ii. Market Making

In addressing the statutory definitions' “making a market” test, the Proposing Release noted that while continuous two-sided quotations and a willingness to buy and sell a security are important indicators of market making in the equities market, these indicia may not be appropriate in the swap and security-based swap markets. The proposal also noted that nothing in the statutory text or legislative history suggested the intent to impute a “continuous” activity requirement to the dealer definitions. [35]

iii. No Predominance Test

The Proposing Release further addressed whether a person should be a dealer only if that activity is the person's sole or predominant business, and took the view that such an approach was not consistent with the statutory definition. The Proposing Release rejected this as an unworkable test of dealer status because many parties that commonly are acknowledged as dealers also engage in other businesses that outweigh their swap or security-based swap dealing business in terms of transaction volume or other measures. [36]

iv. Application to New Types of Wwaps and New Activities

The Proposing Release noted that the Commissions intended to apply the dealer definitions flexibly when the development of innovative business models is accompanied by new types of dealer activity, following a facts-and-circumstances approach. [37]

2. Commenters' Views

Numerous commenters addressed the proposed rules and interpretations in connection with the “swap dealer” and “security-based swap dealer” definitions. Several commenters addressed principles that are common to the two dealer definitions, while a number of commenters also addressed interpretations in the Proposing Release that were specific to the “swap dealer” definition.

a. “Hold Themselves Out” and “Commonly Known in the Trade” Tests

Some commenters expressed the view that the persons that hold themselves out as or are commonly known as dealers are easy to identify. [38] In addressing the “hold themselves out” and “commonly known” criteria of the dealer definitions, commenters placed particular focus on whether only dealers engage in the activities cited by the Proposing Release, or whether those activities are common both to dealers and to other users of swaps and security-based swaps. Commenters particularly stated that end users contact potential counterparties, [39] develop new types of swaps or security-based swaps, [40] and propose terms or language for swap or security-based swap agreements. [41] One commenter further stated that identifying dealing activity based on whether a person develops new types of swaps or proposes swap terms would discourage innovation and the free negotiation of swaps. [42] Some commenters stated that merely responding to a request for proposals or quotations should not, in itself, constitute dealing. [43] Commenters also criticized the Proposing Release's suggestion that criteria for identifying dealing activity include membership in a dealer category of a trade association, [44] as well as providing marketing materials and offering a range of financial products. [45] Commenters also argued for more objective criteria for identifying persons “commonly known” as dealers. [46]

Conversely, one commenter said that three particular activities cited in the Proposing Release—membership in a swap association category reserved for dealers, providing marketing materials and expressing a willingness to offer a range of financial products—are indicative of holding oneself out as a dealer or being commonly known in the trade as a dealer, and should be codified in the final rule. [47] Another commenter suggested other factors, such as having a derivatives sales team, that should be treated as indicators of dealer activity. [48] Commenters also expressed the view that this aspect of the dealer definition should focus on whether a person solicits expressions of interest in swaps from a range of market participants, [49] and that end users of swaps can actively seek out and negotiate swaps without necessarily being swap dealers. [50]

b. Market Making

Several commenters generally requested that the Commissions provide more guidance as to which activities constitute making a market in swaps or security-based swaps. [51] Commenters also described various activities as indicating, or not indicating, market making activity. For example, two commenters expressed the view that market making is characterized by entering into swaps on one side of the market and then establishing offsetting positions on the other side of the market. [52] Other commenters equated market making to providing liquidity by regularly quoting bid and offer prices for swaps, and standing ready to enter into swaps. [53] One commenter stated that market making activity is indicated by a person consistently presenting itself as willing to take either side of a trade. [54] Two commenters said that market makers receive tangible benefits (such as reduced trading fees) in return for the obligation to transact when liquidity is required. [55]

In contrast, one commenter said the proposal correctly did not limit market making to consistently quoting a two-sided market, because to do so would insert a loophole into the definition. [56] Some commenters expressed the view that mere active participation in a market or entering into swaps on both sides of a market does not necessarily constitute market making. [57] Others said that occasionally quoting prices on both sides of the market is not market making when done to obtain information about the market or to mask one's view of the market. [58] One commenter stated that futures commission merchants (“FCMs”) and broker-dealers that facilitate customers' entering into swaps are not necessarily market makers. [59] Other commenters urged the Commissions to reject the view that market making requires continuous activity. [60]

A number of commenters addressed the issue of how the dealer definitions should treat swaps or security-based swaps entered into on a trading platform such as a designated contract market (“DCM”), national securities exchange, swap execution facility (“SEF”), or security-based SEF (collectively referred to herein as “exchanges”). [61] Several stated that entering into swaps or security-based swaps on exchanges should not be considered in determining if a person is a dealer. [62] Some of these commenters emphasized the fact that parties would not know the identity of the counterparty to the swap executed on an exchange (i.e., such swaps are “anonymous”), [63] while other commenters said that such swaps do not constitute “accommodating demand” for swaps or “facilitating interest” in swaps. [64] Another commenter said that future means of executing swaps on exchanges are likely to be diverse, and it is premature to draw conclusions about how they should be treated in the dealer definitions. [65]

Two commenters asserted that firms that provide liquidity in cleared and exchange-executed swaps by actively participating in the market provide heterogeneity among liquidity providers and thereby disperse risk, and further stated that to regulate such persons as swap dealers subject to increased capital requirements would discourage their participation in the market and increase risk. [66]

One commenter expressed the view that the statutory definition uses dealing and market making interchangeably, and suggested that the analysis of whether a person acts as a dealer should be subsumed within the analysis of whether it acts as a market maker. [67]

c. Exception for Activities Not Part of a “Regular Business”

Several commenters addressed the exception from the dealer definitions for swap or security-based swap activities that are not part of a “regular business.” Some commenters supported the Commissions' proposed interpretation in the context of the “swap dealer” definition and stated that this interpretation should be codified in the text of the final rule. [68]

Many commenters said that the activity of entering into swaps or security-based swaps should not be deemed to be a “regular business,” and thus not indicative of dealing activity, when the person's use of swaps or security-based swaps are ancillary to, or in connection with, a separate non-swap business that is the person's primary business. [69] Some commenters making this point said that when the person's primary business relates to physical commodities, the person's use of swaps relating to those commodities does not constitute a “regular business.” [70] Other commenters stated that where a person enters into swaps to serve its own business needs, as opposed to serving the business needs of the counterparty, the person's use of swaps does not constitute a “regular business.” [71] Other commenters said that the use of swaps to hedge the commercial risks of a business does not constitute a “regular business” of entering into swaps. [72] Some commenters also suggested that the “regular business” exclusion should be interpreted to mean “regular swap dealing business” or “regular security-based swap dealing business” to prevent the dealer definitions from capturing hedgers. [73]

On the other hand, two commenters said that the proposed interpretation was correct in the view that the test of whether a person has a “regular business” of entering into swaps does not necessarily depend on whether a person's swap activities are a predominant activity, because such an approach would allow a person to engage in a significant level of swap dealing activity without registering as a swap dealer simply because the person also has substantial activities in a non-swap business or businesses. [74]

Other commenters suggested that the types of swap activities that a person engages in are relevant to determining whether the person has a “regular business” of entering into swaps. One commenter stated that a person has a “regular business” of entering into swaps when the person has a primary business of accommodating demand or facilitating interest in swaps, [75] while others similarly emphasized that a “regular business” of entering into swaps is characterized by financial intermediation activities. [76] One commenter took the view that a person that enters into swaps primarily with financial intermediaries does not have a “regular business” of entering into swaps. [77]

Some commenters said that the final rule should clarify the point at which a person's episodic or occasional swap activities become a “regular business” of entering into swaps. [78] Others stated that the fact that a person enters into swaps frequently or with a large number of counterparties does not necessarily mean that the person has a “regular business” of entering into swaps. [79]

Commenters proposed specific tests for determining if a person has a “regular business” of entering into swaps. One commenter said the determination should look to whether a person enters into swaps to accommodate demand from other parties and to profit from a bid/ask spread on swaps (as opposed to swaps that are substitutes for physical transactions or positions and used by at least one party to hedge commercial risk), and consider specifically the volume, revenues and profits of such activities, the person's value at risk (VaR) and exposure from such activities, and its resources devoted to such activities. [80] Another commenter said that the determination should be based on the nature of the person's business, the person's business purpose for using swaps, and the person's method of executing swap transactions (e.g., a person whose business primarily relates to physical commodities, who uses swaps to hedge commercial risk, and who executes swaps on an exchange would be less likely to have a “regular business” of entering into swaps). [81]

One commenter argued that the “regular business” exception should apply to all four of the dealer tests—not only the test for persons that regularly enters into swaps or security-based swaps as an “ordinary course of business”—and further argued that the “regular business” exception should be linked to a “two-way market” base requirement to avoid commercial hedgers being encompassed by the dealer definitions. [82]

d. Other Dealer Issues

Commenters also addressed other issues in the Proposing Release, including: (i) Whether Congress intended that there be implicit preconditions to dealer status; (ii) whether the concepts of “accommodating demand” for swaps or security-based swaps or “facilitating interest” in swaps are useful in identifying dealers; and (iii) whether the interpretation of the dealer definitions should depend on pre-defined, objective criteria.

i. Preconditions

Several commenters said that the proposal is overbroad and would encompass persons that Congress did not intend to regulate as dealers. [83] Comments in this vein said that the statutory definition should be interpreted to require that persons meet certain criteria or engage in certain activity, not explicitly stated in the statute, to be covered by the swap dealer definition. For instance, some commenters said that a dealer is a person who enters into swaps or security-based swaps on either side of the market and who profits from fees for doing so, or from the spread between the terms of swaps on either side of the market. [84] Other commenters made a similar point, saying that swap dealers are those persons that intermediate between swap users on either side of the market. [85]

The commenters were not all in agreement on this, however. Several commenters (including some of those that said swap dealers enter into swaps on both sides of the market) also stated that there are a variety of situations in which a person's activity of contemporaneously entering into swaps on both sides of the market is not indicative of dealing activity. [86] One commenter said that it would not be appropriate to require that a person enter into swaps or security-based swaps on both sides of the market as a litmus test for dealer status, because to do so would create loopholes in the definition. [87] Two commenters also supported rejection of any interpretation that would limit the dealer definitions to encompass only those entities that solely or predominately act as dealers. [88]

In addition, commenters were particularly divided as to whether acting as an intermediary always is indicative of swap dealing, as some commenters said that a person is not a swap dealer when it simply stands between two parties by entering into offsetting swaps with each party. [89]

ii. “Accommodating Demand” and “Facilitating Interest”

A number of commenters addressed the Proposing Release's view that a tendency to accommodate demand for swaps and a general availability to enter into swaps to facilitate other parties' interest in swaps (referred to here as “accommodating demand” and “facilitating interest”) are characteristic of swap dealers. Some commenters stated that accommodating demand and facilitating interest would not be effective factors to identify swap dealers, particularly in bilateral negotiations where it is difficult to say which party is accommodating demand for swaps. [90] Other commenters said the activities of accommodating demand or facilitating interest are indicative of swap dealing only in certain circumstances, such as when they are not related to a person's commodity business, [91] or when done with the purpose of serving the needs of the other party to the swap. [92] Some commenters argued that the statement in the Proposing Release that swap dealers are likely involved in most or all significant parts of the swap markets is incorrect in the market for energy swaps. There, the commenters said, persons can find counterparties for swaps without the intermediation of a swap dealer, and swaps entered into directly by two end users are more frequent. [93]

Other commenters, though, said that the proposal's focus on accommodating demand and facilitating interest strikes the right balance and that the proposed approach is generally correct. [94] Another commenter did not object to including accommodating demand and facilitating risk as factors in the definition, but said that those factors should be applied flexibly. [95]

iii. Application of Objective Criteria, and Additional Factors

Some commenters, specifically addressing the CFTC's proposed interpretive approach to the “swap dealer” definition, said that the final rule should set out objective criteria that market participants could use to determine whether or not they are covered by the definition and therefore required to register as swap dealers. [96] Others focused especially on statements in the Proposing Release to the effect that swap dealers are those persons who “tend to” engage in certain activities, and that persons who engage in certain activities are “likely” to be swap dealers, as being overly subjective and difficult to interpret. [97]

Certain commenters suggested specific objective criteria to use to identify swap dealers. One commenter said that swap dealing activity is characterized by more frequent use of swaps; having substantial staff and technological resources devoted to swaps; a larger portion of revenue and profit being derived from swap activity; and owning fewer physical assets related to the type of swaps entered into. [98] Another commenter said that to identify swap dealers, the CFTC should compare a person's revenue or profits generated by swap activity to its overall revenue or profits; compare a person's total business volume to the volume, VaR and exposure associated with the swap activity; compare a person's total business resources to the resources devoted to swap activity; and consider ownership or control of physical assets in the specific market or region to which the person's swap activity is tied. [99]

More generally, some commenters supported codification of more concrete tests in connection with the dealer definitions. [100] However, other commenters said that the use of bright line rules to determine whether a person is a dealer would be inappropriate given the dynamic nature of the swap and security-based swap markets. These commenters supported a facts and circumstances approach to the dealer definition as a better approach. [101] One commenter also raised issues about the sources of information that may be considered as part of a dealer determination. [102]

e. Application of Exchange Act “Dealer-Trader” distinction

i. Security-Based Swap Dealer Definition

A number of commenters supported the proposed use of the dealer-trader distinction under the Exchange Act to interpret the “security-based swap dealer” definition. [103] Two commenters, however, specifically opposed use of the distinction in the context of security-based swaps, arguing that use of the distinction would create confusion or would be inconsistent with the goal of improved transparency. [104]

ii. Swap Dealer Definition

Some commenters said that the CFTC should apply the dealer-trader distinction as it has been interpreted with respect to the definition of “dealer” under the Exchange Act to identify swap dealers. [105] Some commenters said that the applicable interpretations under the Exchange Act mean that swaps a person uses for proprietary trading (including for speculative purposes) should not be considered in determining if the person is a swap dealer because dealers enter into transactions in order to profit from spreads or fees regardless of their view of the market for the underlying item, whereas traders enter into transactions in order to take a view on the direction of the market or to obtain exposure to movements in the price of the underlying item. [106] Two commenters said that if the CFTC applied the distinction, traders should be subject to potential registration as major swap participants, and dealers should be subject to regulation as swap dealers. [107] Commenters acknowledged differences between the market for swaps and the market for securities, but said that the Exchange Act interpretations are still relevant. [108]

On the other hand, some commenters agreed with the CFTC's view not to apply Exchange Act interpretations to the definition of the term “swap dealer.” These commenters said that it is appropriate not to apply the interpretations under the Exchange Act to identify persons that meet the swap dealer definition under the CEA. [109]

e. Application to Particular Swap Markets

i. Aggregators

Certain commenters addressed persons who enter into swaps as aggregators, with most of those commenters discussing agricultural cooperatives. Commenters said that agricultural cooperatives that hedge their own risks or the risks of their members regarding agricultural commodities should be excluded from the swap dealer definition because Congress did not intend to treat agricultural cooperatives as swap dealers and because agricultural cooperatives are in effect an extension of their members. [110] Some commenters said that the agricultural cooperatives' use of swaps allows their members to hedge risks when the members' transactions are too small for (or otherwise not qualified for) the futures markets. [111]

Some commenters said that an exclusion from the swap dealer definition also should be available to private companies that serve as aggregators for swaps in agricultural commodities or otherwise offer swaps for agricultural risk management. [112] These commenters said that such an exclusion would reduce the costs and regulatory burdens imposed on such companies and therefore provide a broader choice of swap providers to farmers and other agricultural market participants, which they said would reduce risks. [113]

One commenter discussed a small energy firm that aggregates demand for swaps from small energy retailers and consumers. This commenter said that such aggregators should be excluded from the swap dealer definition because imposing the swap dealer regulations (which would be promulgated with large financial firms in mind) on such firms would increase costs for the aggregators, discourage the aggregators' offering of swaps, and thereby reduce choice and efficiency in the market. [114] Another commenter said that a firm that enters into swaps with microfinance lenders and offsetting swaps with commercial banks is akin to an introducing broker or FCM, and should be excluded from the swap dealer definition on the grounds that it does not enter into swaps on its own initiative, but rather to provide access to the swap markets to smaller counterparties. [115]

Another commenter said that there is no need for any special treatment of aggregators in the swap dealer definition. According to this commenter, the CFTC's guidance regarding the definition and the de minimis exception from the definition address the relevant issues properly and completely. [116]

ii. Physical Commodity Swaps

Commenters that discussed physical commodity swaps primarily focused on swaps related to energy commodities such as oil, natural gas and electricity. The commenters said that the market for these swaps is different from the market for swaps on interest rates and other financial commodities because, among other things, the swaps are used to mitigate price and delivery risks directly linked to a commercial enterprise; less swap activity flows through intermediaries; the markets for the underlying physical commodities are separately regulated; and the failure of a commodity market participant is not likely to impact financial markets as a whole. [117] Therefore, these commenters believe, the application of the swap dealer definition to participants in these physical commodity swap markets should be different from the application to participants in the financial commodity swap markets. [118] Some commenters said that imposing the costs of swap dealer regulation on participants in the markets for physical commodity swaps would discourage participation in the market, thereby reducing liquidity and increasing market concentration. [119]

iii. Electricity Swaps

Commenters on the use of swaps in connection with the generation and transmission of electricity addressed a variety of issues. First, commenters said that markets related to electricity are different from markets for other physical commodities in that electricity must be generated and transmitted at the time it is needed (it cannot be stored for future use); the overall demand for electricity is inelastic but demand at any particular time is subject to external variables, such as weather; the generation, transmission and use of electricity is widely dispersed and geographically specific; the markets are overseen by regulators such as state Public Utility Commissions, regional transmission organizations (“RTOs”) and the Federal Energy Regulatory Commission (“FERC”); and government mandates require continuous supply of electricity and treat electricity as a “public good.” [120] Commenters said that because of these differences, the use of swaps related to electricity is different from the use of swaps on other physical commodities in that electricity swaps: Are more highly customized to a particular place and time; are more likely to relate to a short time period or be more frequently entered into; typically can be tied to a specific generation, transmission or use of electricity; are more likely to be entered into directly by end-users rather than through dealers; are likely to be entered into by electricity companies on both sides of the market; and in many cases were subject to regulatory oversight prior to the Dodd-Frank Act. [121]

Commenters made various points regarding how swaps related to electricity should be treated for purposes of the swap dealer definition. A coalition of not-for-profit power utilities and electric cooperatives said that electricity cooperatives should be excluded from the swap dealer definition because they are non-profit entities that enter into swaps for the benefit of their members, they do not hold themselves out as swap dealers, they do not make markets, and their swaps are not necessarily reflective of market rates. [122] Other commenters said that swaps related to transactions on tariff schedules approved by FERC or the Electric Reliability Council of Texas should be disregarded in determining if a person is a swap dealer. [123] And, some commenters said that any special treatment of swaps related to electricity should apply not only to companies that generate, transmit or distribute electricity, but also to energy marketing companies that use swaps to benefit from price changes in the underlying energy commodities or to hedge related risks. [124]

On the other hand, some commenters acknowledged that a person who makes a market in swaps related to electricity by standing ready to enter into such swaps in order to profit from a bid/ask spread would be a swap dealer, even if the person was in the business of generating, transmitting or distributing electricity and owned physical facilities for that purpose. [125]

f. Suggested Exlusions From the Dealer Definitions

Several commenters took the view that the swap dealer and security-based swap dealer definitions should categorically exclude, or should be interpreted in a way that would be expected to exclude, a variety of types of persons or transactions. Commenters particularly suggested that the following categories of persons should be excluded from the dealer definitions: Agricultural cooperatives and electric cooperatives (as addressed above), employee benefit plans as defined in the Employee Retirement Income Security Act of 1974 (“ERISA”), [126] farm credit system institutions, [127] Federal Home Loan Banks, [128] insured depository institutions that limit their swap dealing activity to riskless principal transactions, [129] FCMs and broker-dealers that limit their swap dealing activity to riskless principal transactions, [130] financial guaranty insurers and their affiliates that do not enter into new swaps, [131] asset managers, [132] non-financial companies offering swaps related to their physical commodity business, [133] any person who enters into swaps or security-based swaps only with registered dealers and major participants, [134] persons that do not pose systemic risk, [135] hedge funds [136] and entities that enter into swaps or security-based swaps solely in a fiduciary capacity. [137]

Commenters also suggested that the dealer definitions categorically exclude, or should be interpreted to exclude, the following types of swaps and security-based swaps: Exchange-cleared swaps and security-based swaps, [138] options to make or receive delivery of physical commodities, [139] cash forward transactions with embedded swaps and book-out transactions, [140] swaps or security-based swaps that are used for hedging or mitigating commercial risk, [141] swaps entered into to profit from future changes in the price of the underlying commodity, [142] swaps or security-based swaps entered into as a fiduciary or agent for another person, [143] swaps or security-based swaps entered into for purposes of price discovery, [144] and, as noted above, swaps related to items that are covered by a tariff approved by FERC or the Electric Reliability Council of Texas. [145]

In contrast, some commenters opposed providing any categorical exclusions from the dealer definitions. One commenter stated that the definitions' focus on a person's activities—as opposed to whether that person falls within a particular category—is a better means of determining whether the person is a swap dealer. [146] Another commenter described the requested exclusions as attempts to achieve carve-outs that are not provided for in the statute. [147]

Lastly, several commenters addressed the extraterritorial application of the definitions of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” In general, the commenters addressed when and how the definitions should be applied to persons based outside the U.S. and how the definitions should take account of non-U.S. requirements that may be applicable to such persons. [148] The Commissions intend to separately address issues related to the application of these definitions to non-U.S. persons in the context of the application of Title VII to non-U.S. persons.

g. Cost-Benefit Issues and Hedging Deterrence

Several commenters emphasized the cost of being regulated as a dealer, and emphasized that an overbroad scope of the dealer definitions would impose significant unwarranted costs on entities contrary to the goals of the Dodd-Frank Act, and would deter the use of swaps and security-based swaps for hedging. [149] Some commenters also noted that impact of the provisions of section 716 of the Dodd-Frank Act on entities that are deemed to be swap dealers or security-based swap dealers. [150] Also, one commenter suggested that using a qualitative test for the dealer definition might increase costs due to regulatory uncertainty. [151]

One commenter specifically suggested that in considering the final rules, the Commissions should consider empirical data regarding the costs and benefits flowing from the rules and issue a second analysis of the costs and benefits of the rules for public comment, [152] while other commenters said that the consideration of cost and benefits should include the cumulative cost of interrelated regulatory burdens arising from all the rules proposed under the Dodd-Frank Act. [153] Other commenters said the Commissions should consider alternatives that would impose fewer costs. [154]

Another commenter said that the cost-benefit analyses in the Proposing Release may have understated the benefits of the proposed rules, because focusing on individual aspects of all the rules proposed under the Dodd-Frank Act prevents consideration of the full range of benefits that arise from the rules as a whole, in terms of providing greater financial stability, reducing systemic risk and avoiding the expense of assistance to financial institutions in the future. [155] This commenter said the consideration of benefits of the proposed rules should include the mitigated risk of a financial crisis. [156]

3. Final Rules and Interpretation—General Principles

Consistent with the Proposing Release, the final rules that define the terms “swap dealer” and “security-based swap dealer” closely follow the statutory definitions' four tests and exclusion for activities that are not part of a “regular business.” [157] In addition, this Adopting Release sets forth interpretive guidance regarding various elements of the final rules.

Because the definitions of the terms “swap dealer” in the CEA and “security-based swap dealer” in the Exchange Act are substantially similar, the rules further defining those terms and the accompanying interpretations in this Adopting Release reflect common underlying principles. At the same time, the interpretations regarding the application of the definitions differ in certain respects given the differences in the uses of and markets for swaps and security-based swaps. [158] For example, because security-based swaps may be used to hedge or gain economic exposure to underlying individual securities (while recognizing distinctions between security-based swaps and other types of securities, as discussed below), there is a basis to build upon the same principles that presently are used to identify dealers for other types of securities. These same principles, though instructive, may be inapplicable to swaps in certain circumstances or may be applied differently in the context of dealing activities involving commodity, interest rate, or other types of swaps.

For these reasons, we separately are addressing the interpretation of the “swap dealer” and “security-based swap dealer” definitions.

Also, as discussed below, the Commissions are directing their respective staffs to report separately regarding the rules being adopted in connection with the definition and related interpretations. These staff reports will help the Commissions evaluate the “swap dealer” and “security-based swap dealer” definitions in all respects, including whether new or revised tests or approaches would be appropriate for identifying swap dealers and security-based swap dealers. [159]

4. Final Rules and Interpretation—Definition of “Swap Dealer”

The Dodd-Frank Act contains a comprehensive definition of the term “swap dealer,” based upon types of activities. As noted above, we are adopting a final rule under the CEA that, like the proposed rule, defines the term “swap dealer” using terms from the four statutory tests and the exclusion for swap activities that are not part of “a regular business.” [160] The final rule includes modifications from the proposed rule that are described below, including provisions stating that swaps entered into for hedging physical positions as defined in the rule, swaps between majority-owned affiliates, swaps entered into by a cooperative with its members, and certain swaps entered into by registered floor traders, are excluded from the swap dealer determination. [161] The Commissions, in consideration of comments received, are also making certain modifications to the interpretive guidance set out in the Proposing Release with respect to various elements of the statutory definition of the term “swap dealer,” as described below.

The determination of whether a person is covered by the statutory definition of the term “swap dealer” requires application of various provisions of the rule further defining that term, as well as the interpretive guidance in this Adopting Release, depending on the person's particular circumstances. We intend that the determination with respect to a particular person would proceed as follows.

The person would begin by applying the statutory definition, and the provisions of the rule which implement the four statutory tests and the exclusion for swap activities that are not part of “a regular business,” [162] in order to determine if the person is engaged in swap dealing activity. In that analysis, the person would apply the interpretive guidance described in this part II.A.4, which provides for consideration of the relevant facts and circumstances. As part of this consideration, the person would apply elements of the dealer-trader distinction, as appropriate, including as described in part II.A.4.a, below.

The rule provides that certain swaps are not considered in the determination of whether a person is a swap dealer. [163] In particular, swaps entered into by an insured depository institution with a customer in connection with originating a loan with that customer, [164] swaps between majority-owned affiliates, [165] swaps entered into by a cooperative with its members, [166] swaps entered into for hedging physical positions as defined in the rule, [167] and certain swaps entered into by registered floor traders [168] are excluded from the swap dealer determination.

If, after completing this review (taking into account the applicable interpretive guidance and excluding any swaps as noted above), the person determines that it is engaged in swap dealing activity, the next step is to determine if the person is engaged in more than a de minimis quantity of swap dealing. [169] If so, the person is a swap dealer. When the person registers, it may apply to limit its designation as a swap dealer to specified categories of swaps or specified activities of the person in connection with swaps. [170]

In this part II.A.4., we provide interpretive guidance on the application of the “swap dealer” definition, modified from the Proposing Release as appropriate based on comments received. This guidance separately addresses the following: application of the dealer-trader framework; the “holding out” and “commonly known” criteria; market making; the not part of “a regular business” exception; the exclusion of swaps entered into for hedging physical positions as defined in the rule; and the overall interpretive approach to the definition. [171]

a. Use of the Dealer-Trader Distinction

We believe that the dealer-trader distinction [172] —which already forms a basis for identifying which persons fall within the longstanding Exchange Act definition of “dealer”—in general provides an appropriate framework for interpreting the statutory definition of the term “swap dealer.” [173] While there are differences in the structure of those two statutory definitions, [174] we believe that their parallels—particularly their exclusions for activities that are “not part of a regular business”—warrant analogous interpretive approaches for distinguishing dealers from non-dealers. [175] Thus, the dealer-trader distinction forms the basis for a framework that appropriately distinguishes between persons who should be regulated as swap dealers and those who should not. We also believe that the distinction affords an appropriate degree of flexibility to the analysis, and that it would not be appropriate to seek to codify the distinction in rule text.

The Commissions recognize that the dealer-trader distinction needs to be adapted to apply to swap activities in light of the special characteristics of swaps and the differences between the “dealer” definition, on the one hand, and the “swap dealer” definition, on the other. Relevant differences between the swap market and the markets for securities (other than security-based swaps) include:

  • Level of activity—Swap markets are marked by less activity than markets involving certain types of securities (while recognizing that some debt and equity securities are not actively traded). This suggests that in the swap context, concepts of “regularity” should account for a participant's level of activity in the market relative to the total size of the market.
  • No separate issuer—Each counterparty to a swap in essence is the “issuer” of that instrument; in contrast, dealers in cash market securities generally transact in securities issued by another party. This distinction suggests that the concept of maintaining an “inventory” of securities is inapposite in the context of swaps. Moreover, this distinction—along with the fact that the “swap dealer” definition lacks the conjunctive “buying and selling” language of the “dealer” definition—suggests that concepts of two-sided markets at times would be less relevant for identifying swap dealers than they would be for identifying dealers. [176]
  • Predominance of over-the-counter and non-standardized instruments—Swaps an thus far are not significantly traded on exchanges or other trading systems, in contrast to some cash market securities (while recognizing that many cash market securities also are not significantly traded on those systems). [177] These attributes—along with the lack of “buying and selling” language in the swap dealer definition, as noted above—suggest that concepts of what it means to make a market need to be construed flexibly in the contexts of the swap markets.
  • Mutuality of obligations and significance to “customer” relationship—In contrast to a secondary market transaction involving equity or debt securities, in which the completion of a purchase or sale transaction can be expected to terminate the mutual obligations of the parties to the transaction, the parties to a swap often will have an ongoing obligation to exchange cash flows over the life of the agreement. In light of this attribute, some market participants have expressed the view that they have “counterparties” rather than “customers” in the context of their swap activities.

In applying the dealer-trader distinction, it also is necessary to apply the statutory provisions that will govern swap dealers in an effective and logical way. Those statutory provisions added by the Dodd-Frank Act advance financial responsibility (e.g., the ability to satisfy obligations, and the maintenance of counterparties' funds and assets) associated with swap dealers' activities, [178] other counterparty protections, [179] and the promotion of market efficiency and transparency. [180] As a whole, the relevant statutory provisions suggest that we should interpret the “swap dealer” definition to identify those persons for which regulation is warranted either: (i) Due to the nature of their interactions with counterparties; or (ii) to promote market stability and transparency, in light of the role those persons occupy within the swap and security-based swap markets.

There are several aspects of our interpretive approach to the swap dealer definition that are particularly similar to the dealer-trader distinction as it will be applied to determine if a person is a security-based swap dealer. In particular, the following activities, which are indicative of dealing activity in the application of the dealer-trader distinction, [181] similarly are indicative that a person is acting as a swap dealer: [182] (i) Providing liquidity by accommodating demand for or facilitating interest in the instrument (swaps, in this case), holding oneself out as willing to enter into swaps (independent of whether another party has already expressed interest), or being known in the industry as being available to accommodate demand for swaps; (ii) advising a counterparty as to how to use swaps to meet the counterparty's hedging goals, or structuring swaps on behalf of a counterparty; (iii) having a regular clientele and actively advertising or soliciting clients in connection with swaps; [183] (iv) acting in a market maker capacity on an organized exchange or trading system for swaps; [184] and (v) helping to set the prices offered in the market (such as by acting as a market maker) rather than taking those prices, although the fact that a person regularly takes the market price for its swaps does not foreclose the possibility that the person may be a swap dealer.

The Commissions further note that the following elements of the interpretive approach to the swap dealer definition are also generally consistent with the dealer-trader distinction as it will be applied to determine if a person is a security-based swap dealer: (i) A willingness to enter into swaps on either side of the market is not a prerequisite to swap dealer status; (ii) the swap dealer analysis does not turn on whether a person's swap dealing activity constitutes that person's sole or predominant business; (iii) a customer relationship is not a prerequisite to swap dealer status; and (iv) in general, entering into a swap for the purpose of hedging, absent other activity, is unlikely to be indicative of dealing. Last, under the interpretive approach to the definition of both the terms “swap dealer” and “security-based swap dealer,” whether a person is acting as a dealer will turn upon the relevant facts and circumstances, as informed by the interpretive guidance set forth in this Adopting Release.

At the same time, the Commissions recognize that the dealer-trader distinction is not static, but rather has evolved over time through interpretive materials. The Commissions expect the dealer-trader distinction to evolve over time with respect to swaps independently of its evolution over time with respect to securities or security-based swaps. Prior interpretations and future developments in the law regarding securities or security-based swaps may inform the interpretation of the swap dealer definition, but will not be dispositive in identifying dealers in the swap markets. [185]

b. Indicia of Holding Oneself Out as a Dealer in Swaps or Being Commonly Known in the Trade as a Dealer in Swaps

The final rule further defining the term “swap dealer” includes the provisions in the proposed rule which incorporate the statutory requirements that the term includes a person that is holding itself out as a dealer in swaps or is engaging in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. [186]

We continue to believe that the Proposing Release appropriately identifies a number of factors as indicia of “hold[ing] itself out as a dealer in swaps” and “engag[ing] in any activity causing [itself] to be commonly known in the trade as a dealer or market maker in swaps.” [187] In our view, those factors thus are relevant to determining if a person is a swap dealer. For example, regarding the proposed factor of “membership in a swap association in a category reserved for dealers,” we note that the bylaws of the International Swaps and Derivatives Association (“ISDA”) provide that any business organization that:

Directly or through an affiliate, as part of its business (whether for its own account or as agent), deals in derivatives shall be eligible for election to membership in the Association as a Primary Member, provided that no person or entity shall be eligible for membership as a Primary Member if such person or entity participates in derivatives transactions solely for the purpose of risk hedging or asset or liability management. [188]

We believe that in circumstances such as this, where a category of association membership requires that a person deal in derivatives and not limit its participation in derivative transactions to solely risk hedging, membership in the category is an indicator of swap dealer status. [189]

We take note, however, of the comments that these activities may be insufficient to establish that a person is a swap dealer. In particular, we generally agree with commenters that many commercial end users of swaps do, from time to time, actively seek out and negotiate swaps. Yet, based on the applicable facts and circumstances, these end users do not necessarily fall within the definition of a swap dealer solely because they actively seek out and negotiate swaps from time to time.

The activities described in the Proposing Release as indicia of holding oneself out as a swap dealer or engaging in any activity causing oneself to be commonly known as a swap dealer should not be considered in a vacuum, but should instead be considered in the context of all the activities of the swap participant. While the activities listed in the Proposing Release are indicators that a person is holding itself out or is commonly known as a swap dealer, these are factors to be considered in the analysis. They are not per se conclusive, and could be countered by other factors indicating that the person is not a swap dealer. [190] Because of the flexibility—including the consideration of applicable facts and circumstances—needed for such an analysis, we do not believe that it is appropriate to codify this guidance in rule text, as suggested by some commenters.

c. Market Making

The final rule defining “swap dealer” includes the provision from the proposed rule which incorporates the statutory requirement that this term include a person that “makes a market in swaps.” [191]

We have considered the comments suggesting various descriptions of activities that should and should not be deemed to be market making in swaps for purposes of this rule. In consideration of these comments, we clarify that making a market in swaps is appropriately described as routinely standing ready to enter into swaps at the request or demand of a counterparty. In this regard, “routinely” means that the person must do so more frequently than occasionally, but there is no requirement that the person do so continuously. [192]

It is appropriate, in response to comments asking for further guidance regarding what activities constitute making a market in swaps, to describe some of the activities indicative of whether a person is routinely standing ready to enter into swaps at the request or demand of a counterparty. Such activities include routinely: (i) Quoting bid or offer prices, rates or other financial terms for swaps on an exchange; (ii) responding to requests made directly, or indirectly through an interdealer broker, by potential counterparties for bid or offer prices, rates or other similar terms for bilaterally negotiated swaps; (iii) placing limit orders for swaps; or (iv) receiving compensation for acting in a market maker capacity on an organized exchange or trading system for swaps. [193] These examples are not exhaustive, and other activities also may be indicative of making a market in swaps if the person engaging in them routinely stands ready to enter into swaps as principal at the request or demand of a counterparty.

In determining whether a person's routine presence in the market constitutes market making under these four factors, the dealer-trader interpretative framework may be usefully applied. [194] Under the dealer-trader distinction, seeking to profit by providing liquidity to the market is an indication of dealer activity. [195] Thus, in applying these four factors, it is useful to consider whether the person is seeking, through presence in the market, compensation for providing liquidity, compensation through spreads or fees, or other compensation not attributable to changes in the value of the swaps it enters into. [196] If not, such activity would not be indicative of market making.

Some commenters suggested that, in order to be a market maker in swaps, a person must make a two-way market in swaps. [197] Nonetheless, it is possible for a person making a one-way market in swaps to be a maker of a market in swaps and, therefore, within the swap dealer definition. This may be true, for example, where a person routinely stands ready to enter into swaps on a particular side of the market—say, routinely bidding for floating exposures on a swap trading platform—while entering into transactions on the other side of the market in other instruments (such as futures contracts). The relevant indicator of market maker status is the willingness of the person to routinely stand ready to enter into swaps at the request or demand of a counterparty (as opposed to entering into swaps to accommodate one's own demand or desire to participate in a particular market), be it on one or both sides of the market, and then to enter into offsetting positions, either in the swap market or in other markets.

The Commissions disagree with the commenters who said that swaps executed on an exchange should not be considered in determining if a person is a market maker in swaps and thus a swap dealer. [198] First, the statutory definition of the term “swap dealer” makes no distinction between swaps executed on an exchange and swaps that are not, suggesting that the same protections should apply regardless of the method of executing the swap. Second, from the perspective of an end user seeking to execute a swap on an exchange, the important consideration under our analysis is whether a market maker is ready to enter into swaps, not whether the market maker is aware of the counterparty's identity. A market maker in swaps routinely stands ready to enter into swaps at the request or demand of a counterparty, regardless of whether the counterparty and the market maker meet on a disclosed basis through bilateral negotiations or anonymously through an exchange. [199] Similarly, the issue of whether a person is a registered FCM or broker-dealer is not necessarily relevant to whether the person is a maker of a market in swaps, if the person is routinely standing ready to enter into swaps at the request or demand of a counterparty. Third, we believe it would be inappropriate to disregard swaps executed on exchanges in order, as some commenters suggested, [200] to encourage market participants to use, or to provide liquidity to, exchanges. Finally, variety of exchanges, markets, and other facilities for the execution of swaps are likely to evolve in response to the requirements of the Dodd-Frank Act, and there is no basis for any bright-line rule excluding swaps executed on an exchange, given the impossibility of obtaining information about how market participants will interact and execute swaps in the future, after the requirements under the Dodd-Frank Act are fully in effect. For all these reasons, we have determined that it is inappropriate to restrict the “making a market in swaps” prong of the swap dealer definition (i.e., routinely standing ready to enter into swaps at the request or demand of a counterparty) to swaps that are not executed on an exchange. [201]

d. Exception for Activities Not Part of “a Regular Business”

The final rule includes the provisions in the proposed rule that incorporate the provisions of the statutory definition regarding activities that are not part of “a regular business” of entering into swaps. One provision states that the term “swap dealer” includes a person that “regularly enters into swaps with counterparties as an ordinary course of business for its own account”; the other provision states that the term “swap dealer” does 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.” [202]

The Commissions continue to believe, as stated in the Proposing Release, that the phrases “ordinary course of business” and “a regular business” are, for purposes of the definition of “swap dealer” essentially synonymous. In this context, we interpret these phrases to focus on activities of a person that are usual and normal in the person's course of business and identifiable as a swap dealing business. It is not necessarily relevant whether the person conducts its swap-related activities in a dedicated subsidiary, division, department or trading desk, or whether such activities are a person's “primary” business or an “ancillary” business, so long as the person's swap dealing business is identifiable. [203]

We have taken into consideration comments seeking additional guidance regarding the types and levels of activities that constitute having “a regular business” of entering into swaps. [204] In this regard, any one of the following activities would generally constitute both entering into swaps “as an ordinary course of business” and “as a part of a regular business”: [205] (i) Entering into swaps with the purpose of satisfying the business or risk management needs of the counterparty (as opposed to entering into swaps to accommodate one's own demand or desire to participate in a particular market); (ii) maintaining a separate profit and loss statement reflecting the results of swap activity or treating swap activity as a separate profit center; or (iii) having staff and resources allocated to dealer-type activities with counterparties, including activities relating to credit analysis, customer onboarding, document negotiation, confirmation generation, requests for novations and amendments, exposure monitoring and collateral calls, covenant monitoring, and reconciliation. [206]

The Commissions see merit in the comments saying that “a regular business” of entering into swaps can be characterized by entering into swaps to satisfy the business or risk management needs of the other party to the swap, and so incorporate this element into our interpretation of the rule. [207] Also, an objective indicator of a person being engaged in “a regular business” of entering into swaps is when the person accounts for the results of its swap activities separately, by maintaining a separate profit and loss statement for those activities or treating them as a separate profit center. Our interpretation incorporates this indicator of activity that is “a regular business” of entering into swaps.

Other comments suggesting specific criteria to identify “a regular business” also were helpful. We agree with commenters [208] that “a regular business” of entering into swaps can be characterized by having staff and resources allocated to the types of activities in which swap dealers must engage with their counterparties, such as those noted above (e.g., credit analysis, confirmation generation, collateral calls, and covenant monitoring). However, we understand that some end users of swaps engage in some of these activities and, in certain circumstances, may have staff and resources available for these activities. Therefore, this element of the definition should be applied in a reasonable manner, taking all appropriate circumstances into account. This element does not depend on whether a specific amount or percentage of expenses or employee time are related to these swap activities. Instead, it is appropriate to objectively examine a person's use of staff and resources related to swap activities. Using staff and resources to a significant extent in conducting credit analysis, opening and monitoring accounts and the other activities noted above, is an indication that the person is engaged in “a regular business” of entering into swaps.

Regarding the commenters' assertion that the activity of entering into swaps in connection with a person's physical commodity business cannot constitute “a regular business” of the person, we believe that while in most cases this is not dealing activity, [209] a per se exclusion of this type is not appropriate because it is possible that in some circumstances a person might enter into swaps that are connected to a physical commodity business but also serve market functions characteristic of the functions served by swap dealers. Also, again, the statutory definition does not contain any such exclusion, but rather includes any person who “regularly enters into swaps with counterparties as an ordinary course of business for its own account,” without regard to the person's particular type of business.

Consistent with the statutory definition, we interpret “a regular business” of entering into swaps in a manner that applies equally to all market participants that engage in the activities set forth in the statutory definition. This will ensure that all participants in the swap markets are regulated in a fair and consistent manner, regardless of whether their underlying business is primarily physical or financial in nature. [210]

Finally, as noted above, the manner in which persons negotiate, execute and use swaps is likely to evolve in response to the requirements of the Dodd-Frank Act and the other forces that will shape the swap markets going forward. For this reason, it would be inappropriate to craft per se exclusions from the swap dealer definition at a time when the only available information about the use of swaps relates to the period prior to implementation of the Dodd-Frank Act. [211]

e. Interim Final Rule Excluding Swaps Entered Into for Hedging Physical Positions

We note that some commenters said that swaps used to hedge or mitigate commercial risks should not be considered in determining whether a person is a swap dealer. [212] We understand that swaps are used to hedge risks in numerous and varied ways, and we expect that the number of persons covered by the definition will be very small in comparison to the thousands of persons that use swaps for hedging.

In terms of the statutory definition of the term “swap dealer,” the CFTC notes as an initial matter that there is no specific provision addressing hedging activity. Thus, the statutory definition leaves the treatment of hedging swaps to the CFTC's discretion; it neither precludes consideration of a swap's hedging purpose, nor does it require an absolute exclusion of all swaps used for hedging. [213]

In general, entering into a swap for the purpose of hedging is inconsistent with swap dealing. [214] The practical difficulty lies in determining when a person has entered into a swap for the purpose of hedging, as opposed to other purposes for entering into swaps, such as accommodating demand for swaps or as part of making a market in swaps, and in distinguishing a swap with a hedging purpose from a swap with a hedging consequence. In view of these uncertainties, the CFTC believes it is appropriate to adopt an interim final rule that draws upon the principles of bona fide hedging that the CFTC has long applied to identify when a financial instrument is used for hedging purposes, and excludes from the swap dealer analysis swaps entered into for the purpose of hedging physical positions that meet the requirements of the rule.

Specifically, the CFTC is adopting as an interim final rule CFTC Regulation § 1.3(ggg)(6)(iii), which provides that the determination of whether a person is a swap dealer will not consider a swap that the person enters into, if:

(i) The person enters into the swap for the purpose of offsetting or mitigating the person's price risks that arise from the potential change in the value of one or several (a) assets that the person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; (b) liabilities that the person owns or anticipates incurring; or (c) services that the person provides, purchases, or anticipates providing or purchasing;

(ii) the swap represents a substitute for transactions made or to be made or positions taken or to be taken by the person at a later time in a physical marketing channel;

(iii) the swap is economically appropriate to the reduction of the person's risks in the conduct and management of a commercial enterprise;

(iv) the swap is entered into in accordance with sound commercial practices; and

(v) the person does not enter into the swap in connection with activity structured to evade designation as a swap dealer. [215]

Thus, although the CFTC is not incorporating the bona fide hedging provisions of the CFTC's position limits rule here, the exclusion from the swap dealer analysis draws upon language in the CFTC's definition of bona fide hedging. [216] For example, the exclusion expressly includes swaps hedging price risks arising from the potential change in value of existing or anticipated assets, liabilities, or services, if the hedger has an exposure to physical price risk. And, as in the bona fide hedging rule, the exclusion utilizes the word “several” to reflect that there is no requirement that swaps hedge risk on a one-to-one transactional basis in order to be excluded, but rather they may hedge on a portfolio basis. [217] For these reasons, swaps that qualify as enumerated hedging transactions and positions are examples of the types of physical commodity swaps that are excluded from the swap dealer analysis if the rule's requirements are met. [218]

This provision in the final rule is consistent with our overall interpretive approach to the definition of the term “swap dealer.” The interpretations of the statutory dealer definitions by both Commissions focus on a person's activities in relation to its counterparties and other market participants. [219] As noted above, for example, one indicator that a person enters into swaps as part of “a regular business” is that the person does so to satisfy the business or risk management needs of the counterparty. This aspect of the swap dealer analysis turns on the accommodation of a counterparty's needs or demands. If a person enters into swaps for the purpose of hedging a physical position as defined in CFTC Regulation § 1.3(ggg)(6)(iii), by contrast, then the swap can be identified as not having been entered into for the purpose of accommodating the counterparty's needs or demands. [220] Also, a person's activity of seeking out swap counterparties in order to hedge a physical position as defined in the rule generally would not warrant regulations to promote market stability and transparency or to serve the other purposes of dealer regulation. [221]

At the same time, however, there may be circumstances where a person's activity of entering into swaps is encompassed by the statutory definition of the term “swap dealer,” notwithstanding that the swaps have the effect of hedging or mitigating the person's commercial risk. [222] Although these swaps could, in theory, be excluded from the swap dealer analysis, we believe that a broader, per se exclusion for all swaps that hedge or mitigate commercial risk is inappropriate for the swap dealer definition.

First, the hedging exclusion that we are adopting is in the nature of a safe harbor; i.e., it describes activity that will not be considered swap dealing activity. As such, the CFTC believes that it is appropriate that the interim final rule not be cast broadly. [223] This does not mean that other types of hedging activity that do not meet the requirements of the interim final rule are necessarily swap dealing activity. Rather, such hedging activity is to be considered in light of all other relevant facts and circumstances to determine whether the person is engaging in activity (e.g., accommodating demand for swaps, making a market for swaps, etc.) that makes the person a swap dealer.

Second, the usefulness of an exclusion of all swaps that hedge or mitigate commercial risk for certain aspects of the major swap participant definition [224] is not a reason to use the same exclusion in the swap dealer definition, since the swap dealer definition serves a different function. The definition of the term “major swap participant,” which applies only to persons who are not swap dealers, [225] is premised on the prior identification, by the swap dealer definition, of persons who accommodate demand for swaps, make a market in swaps, or otherwise engage in swap dealing activity. The major swap participant definition performs the subsequent function of identifying persons that are not swap dealers, but hold swap positions that create an especially high level of risk that could significantly impact the U.S. financial system. [226] Only for this subsequent function is it appropriate to apply the broader exclusion of swaps held for the purpose of hedging or mitigating commercial risk. [227]

The CFTC believes that since the over-the-counter swap markets have operated largely without regulatory oversight and encompass swaps used for a wide variety of commercial purposes, no method has yet been developed to reliably distinguish, through a per se rule, between: (i) Swaps that are entered into for the purpose of hedging or mitigating commercial risk; and (ii) swaps that are entered into for the purpose of accommodating the counterparty's needs or demands or otherwise constitute swap dealing activity, but which also have a hedging consequence. [228] In contrast, the CFTC notes that it has set forth and modified standards for bona fide hedging transactions and granted exemptions in compliance with such standards for decades. [229] These historically-developed standards form the basis of the interim final rule excluding from the swap dealer analysis certain swaps that hedge the risks associated with a physical position.

The exclusion in CFTC Regulation § 1.3(ggg)(6)(iii) depends not on the effect or consequences of the swap, but on whether the purpose for which a person enters into a swap is to hedge a physical position as defined in the rule. If so, then the swap is excluded from the dealer analysis because using swaps for that purpose is inconsistent with, and is not, dealing activity. [230] On the other hand, if, at the time the swap is entered into, the person's purpose for entering into the swap is not as defined in CFTC regulation § 1.3(ggg)(6)(iii), or if it is unclear whether the swap is for such purpose, then the fact that the swap hedges the person's exposure in some regard does not preclude consideration of that swap in the dealer analysis. [231] In this latter case, all relevant facts and circumstances regarding the swap and the person's activity with respect to the swap would be relevant in the determination of whether the person is a swap dealer. [232]

We believe that, based on the CFTC's experience in applying bona fide hedging principles with respect to swaps hedging risks related to physical positions, the exclusion in CFTC Regulation § 1.3(ggg)(6)(iii) at this time is the best means of providing certainty to market participants regarding which swaps may be disregarded in the dealer analysis. However, commenters presented a range of views as to the exclusions from the dealer analysis that may be appropriate in this regard. [233] Accordingly, the CFTC is implementing this exclusion on an interim rule basis and is seeking comments on all aspects of the interim rule, including any adjustments that may be appropriate in the rule or accompanying interpretive guidance.

The CFTC also seeks comments on whether a different approach to swaps entered into for the purpose of hedging risk is appropriate to implement the statutory definition of the term “swap dealer.”

For example, the CFTC invites commenters to address whether any exclusion of hedging swaps from the swap dealer analysis is appropriate, and if so, how swaps that are entered into for purposes of hedging may be identified and distinguished from other swaps. Commenters are encouraged to address whether it is relevant to distinguish swaps entered into for purposes of hedging from swaps that have a consequential result of hedging, and if so, how such swaps may be distinguished. Also, commenters may address whether the exclusion should be limited to swaps hedging risks related to physical positions or extended to encompass swaps hedging financial risks or other types of risks.

Commenters should address whether the exclusion in CFTC Regulation § 1.3(ggg)(6)(iii) should be consistent with the exclusion in CFTC Regulation § 1.3(kkk). If so, why, and if not, why not? If the two exclusions should be consistent, does consistency require that that exclusions be identical, or would there be variations in application of the two exclusions? Are there market participants whose swap positions would be classified as held for the purpose of hedging or mitigating commercial risk under CFTC Regulation § 1.3(kkk) but would not qualify for the exclusion under CFTC Regulation § 1.3(ggg)(6)(iii)? If so, specifically identify the types of market participants and swaps. If the CFTC were to apply in the swap dealer definition the exclusion in CFTC Regulation § 1.3(kkk) in lieu of the exclusion in CFTC Regulation § 1.3(ggg)(6)(iii), would there be negative market impacts? If so, what are they? Would there be positive market impacts? If so, what are they? In particular, what type(s) of swaps that “hedge or mitigate commercial risk,” but that are not excluded under the interim rule, may constitute dealing activity in light of the rules and interpretive guidance regarding the swap dealer definition set forth in this Adopting Release?

Comments regarding the costs and benefits related to the interim final rule and any alternative approaches, including in particular the quantification of such costs and benefits, are also invited.

Commenters are encouraged, to the extent feasible, to be comprehensive and detailed in providing their approach and rationale. The comment period for the interim final rule will close July 23, 2012.

f. Swaps Entered Into by Persons Registered as Floor Traders

Commenters discussed whether the swap dealer definition encompasses the activity of entering into swaps on or subject to the rules of a DCM or SEF, and submitted for clearing to a derivatives clearing organization (“DCO”), particularly when firms engage in that activity using only proprietary funds. [234] Because Title VII of the Dodd-Frank Act amended the definition of floor trader specifically to encompass activities involving swaps, [235] the CFTC believes that it would lead to potentially duplicative regulation if floor traders engaging in swaps in their capacity as floor traders were also required to register as swap dealers. Accordingly, the CFTC believes that it is appropriate not to consider such swaps when determining whether a person acting as a floor trader, as defined under CEA section 1a(23), [236] and registered with the CFTC under CFTC Regulation § 3.11, is a swap dealer if the floor trader meets certain conditions. Specifically, the final rule provides that, in determining whether a person is a swap dealer, each swap that the person enters into in its capacity as a floor trader as defined by CEA section 1a(23) or on a SEF shall not be considered for the purpose of determining whether the person is a swap dealer, provided that the person:

(i) Is registered with the CFTC as a floor trader pursuant to CFTC Regulation § 3.11;

(ii) enters into swaps solely with proprietary funds for that trader's own account on or subject to the rules of a DCM or SEF, and submits each such swap for clearing to a DCO;

(iii) is not an affiliated person of a registered swap dealer;

(iv) does not directly, or through an affiliated person, negotiate the terms of swap agreements, other than price and quantity or to participate in a request for quote process subject to the rules of a DCM or SEF;

(v) does not directly or through an affiliated person offer or provide swap clearing services to third parties;

(vi) does not directly or through an affiliated person enter into swaps that would qualify as hedging physical positions pursuant to CFTC Regulation § 1.3(ggg)(6)(iii) or hedging or mitigating commercial risk pursuant to CFTC Regulation § 1.3(kkk), with the exception of swaps that are executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction;

(vii) does not participate in any market making program offered by a DCM or SEF; and

(viii) complies with the record keeping and risk management requirements of CFTC Regulation §§ 23.201, 23.202, 23.203, and 23.600 with respect to each such swap as if it were a swap dealer. [237]

This rule permits floor traders who might otherwise be required to register as a swap dealer to be registered solely as floor traders with the CFTC. Given the limitations on the scope of the rule, the requirements for floor traders using the relief to comply with recordkeeping and risk management rules applicable to swap dealers as a condition of the relief, and the fact that swaps subject to the rule are traded on a DCM or SEF and cleared through a DCO, the CFTC believes it is not necessary to have floor traders subject to this rule register as both floor traders and swap dealers as a result of swaps activities covered by the rule. [238]

g. Additional Interpretive Issues Relating to the “Swap Dealer” Definition

As noted above, the Commissions, in consideration of comments received, are making certain modifications to the interpretive guidance concerning the definition of the term “swap dealer” set out in the Proposing Release. However, the Commissions are retaining certain elements of their proposed interpretation of the term “swap dealer,” as discussed below.

First, with respect to the comments asserting that the proposed interpretive approach is overly broad, [239] we note that the statute provides that the term “swap dealer” means “any person” who engages in the activities described in any of the four prongs of the definition, subject to the exceptions and qualifications set out in the statute. In view of this statutory text, these comments effectively assert that the statute should be interpreted to include preconditions to swap dealer status that are not set forth in the statute. For example, the assertion that the swap dealer definition must be limited to persons who enter into swaps on both sides of the market would impose a requirement that does not exist in the statute. Similarly, the comments to the effect that swap dealers are only those persons who seek to profit by intermediating between swap market participants adds a requirement not set forth in the statute.

We believe, though, that the activities that cause a person to be covered by the swap dealer definition should be addressed in the context of the four prongs of the statutory definition. That is, the relevant question is whether a person engages in any of the types of activities enumerated in the statute, and not whether the person meets any additional, supposedly implicit preconditions to swap dealer status.

Second, the Commissions continue to believe, as stated in the Proposing Release, that accommodating demand and facilitating interest are appropriately used as factors in identifying swap dealers. As noted by commenters, however, the mere fact that a person entering into a particular swap has the effect of “accommodating demand” or “facilitating interest” in swaps does not conclusively establish that the person is a swap dealer. Instead, the person's overall activities in the swap market (or particular sector of the swap market if the person is active in a variety of sectors) should be compared against these factors. If, in the context of its overall swap activities, a person fulfills a function of accommodating demand or facilitating interest in swaps for other parties, then these factors would be significant in the analysis and the person is likely to be a swap dealer. [240]

Third, as discussed above, we have adopted some of the objective criteria suggested by commenters with respect to the indicia of holding oneself out as a dealer or being commonly known as a dealer, market making, and the “regular business” prongs of the swap dealer definition. [241] For instance, allocating staff and technological resources to swap activity, deriving revenue and profit from swap activity, or responding to customer-initiated orders for swaps can all be indicative of having “a regular business” of entering into swaps and, therefore, indicative of being a swap dealer. In addition, activities such as providing advice about swaps or offering oneself as a point of connection to other parties needing access to the swap market are indicative of a person holding itself out as a swap dealer, if the person also enters into swaps in conjunction with such activities.

The guidance we have provided about these indicia is responsive to concerns expressed by commenters about the application of the swap dealer definition to energy markets. As described above, some commenters stated that in energy markets, unlike in some other markets, end-users often enter into swaps directly with each other, on both sides of the market, without the involvement of a separate category of businesses serving as intermediaries. [242] As a result, according to these commenters, energy swap market participants often engage in some of the activities that are indicative of swap dealer status. Some of these commenters contended that our activity-based interpretation of the swap dealer definition could therefore result in the inappropriate inclusion of energy market participants in the coverage of the definition of the term “swap dealer.” [243]

We believe that the language of the statutory “swap dealer” definition supports our activity-based interpretation and does not support categorical exclusions of particular types of persons from the “swap dealer” definition based on the general nature of their businesses. Further evidence that such a categorical exclusion is unwarranted is provided by the fact that a number of energy market participants—BP Plc., Cargill, Incorporated, Centrica Energy Limited, ConocoPhillips, EDF Trading Limited, GASELYS, Hess Energy Trading Company, LLC, Hydro-Quebec, Koch Supply & Trading, LP, RWE Supply & Trading GmbH, Shell Energy North America (US), L.P., STASCO, Totsa Total Oil Trading S.A., and Vattenfall Energy Trading Netherlands N.V.—have voluntarily joined ISDA as primary dealers. [244] As previously noted, any business organization that “deals in derivatives shall be eligible for election to membership in the Association as a primary member, provided that no person or entity shall be eligible for membership as a Primary Member if such person or entity participates in derivatives transactions solely for the purpose of risk hedging or asset or liability management.” [245] Hence, a categorical exclusion from the “swap dealer” definition based on any particular type of business or general market activity also would be inconsistent with current industry structure and practice.

At the same time, however, the fact that a person engages in some swap activities that are indicative of swap dealer status does not, by itself, mean that the person is covered by the definition of the term “swap dealer.” The “not as part of a regular business” exception and our guidance about its meaning address the issue of swap market participants that engage to some extent in the activities characteristic of swap dealers. The guidance we have provided here therefore provides the appropriate approach to addressing these issues in energy markets as elsewhere.

Although several commenters attempted to articulate bright-line tests that would differentiate swap dealers from other swap market participants, the suggested bright-line tests generally could not be applied across the board to all types of swap market activity. For example, some commenters suggested that swap dealers can be identified as those who profit from entering into swaps on both sides of the market (and under the interpretive approach set forth in this Adopting Release, such activity may be an indicator of swap dealing). [246] But other commenters said that, in certain circumstances, entering into swaps on both sides of the market is not necessarily indicative of swap dealing. [247]

The ways in which participants throughout the market use swaps are simply too diverse for swap dealer status to be resolved with a single, one-factor test. This is reflected in the statutory definition of the term “swap dealer” itself. Focused as it is on types of activities, with four prongs set forth in the alternative to cover different types of swap dealing activity, the statutory swap dealer definition is not susceptible to the bright-line test that some commenters seek. For these reasons, we continue to believe that it is appropriate to apply the multi-factor interpretive approach set forth in this Adopting Release.

In closing, we emphasize that the purpose of in this part IV.A.4 is to provide guidance as to how the rules further defining the term “swap dealer” will be applied in particular, complex situations where a person's status as a swap dealer may be uncertain. Even though bright-line tests and categorical exclusions are inappropriate, we recognize that the large majority of market participants use swaps for normal course hedging, financial, investment or trading purposes and are not swap dealers.

5. Final Rules and Interpretation—Definition of “Security-Based Swap Dealer”

a. General Reliance on the Dealer-Trader Distinction

As discussed above, we are adopting a rule under the Exchange Act that defines “security-based swap dealer” in terms of the four statutory tests and the exclusion for security-based swap activities that are not as part of a “regular business.” [248] Also, we believe that the dealer-trader distinction [249] —which already forms a basis for identifying which persons fall within the longstanding Exchange Act definition of “dealer”—in general provides an appropriate framework for interpreting the meaning of “security-based swap dealer.” [250] While there are differences in the structure of those two statutory definitions, [251] we believe that their parallels—particularly both definitions' exclusions for activities that are “not part of a regular business”—warrant analogous interpretive approaches for distinguishing dealers from non-dealers.

As discussed above, [252] the Commissions note that interpretations of the applicability of the dealer-trader distinction to the “swap dealer” definition under the CEA do not affect existing, or future, interpretations of the dealer-trader distinction under the Exchange Act—both with regard to the “security-based swap dealer” definition, and with regard to the “dealer” definition.

In interpreting the security-based swap dealer definition in terms of the dealer-trader distinction, the Commissions have been mindful that some commenters expressed the view that we instead should rely on other interpretive factors that were identified in the Proposing Release (e.g., accommodating demand). We believe, nonetheless, that the dealer-trader distinction forms the basis for a framework that appropriately distinguishes between persons who should be regulated as security-based swap dealers and those who should not. We also believe that the distinction affords an appropriate degree of flexibility to the analysis, and that it would not be appropriate to seek to codify the distinction.

At the same time, the Commissions recognize that the dealer-trader distinction needs to be adapted to apply to security-based swap activities in light of the special characteristics of security-based swaps and the differences between the “dealer” and “security-based swap dealer” definitions. Relevant differences include:

  • Level of activity—Security-based swap markets are marked by less activity than markets involving certain other types of securities (while recognizing that some debt and equity securities are not actively traded). This suggests that in the security-based swap context concepts of “regularity” should account for the level of activity in the market.
  • No separate issuer—Each counterparty to a security-based swap in essence is the “issuer” of that instrument; in contrast, dealers in cash market securities generally transact in securities issued by another party. This distinction suggests that the concept of turnover of “inventory” of securities, which has been identified as a factor in connection with the dealer-trader distinction, is inapposite in the context of security-based swaps. Moreover, this distinction—along with the fact that the “security-based swap dealer” definition lacks the conjunctive “buying and selling” language of the “dealer” definition [253] —suggests that concepts of two-sided markets at times would be less relevant for identifying “security-based swap dealers” than they would be for identifying “dealers.” [254]
  • Predominance of over-the-counter and non-standardized instruments—Security-based swaps thus far are not significantly traded on exchanges or other trading systems, in contrast to some cash market securities (while recognizing that many cash market securities also are not significantly traded on those systems). [255] These attributes—along with the lack of “buying and selling” language in the security-based swap dealer definition, as noted above—suggest that concepts of what it means to make a market need to be construed flexibly in the context of the security-based swap market. [256]
  • Mutuality of obligations and significance to “customer” relationship—In contrast to a secondary market transaction involving equity or debt securities, in which the completion of a purchase or sale transaction can be expected to terminate the mutual obligations of the parties to the transaction, the parties to a security-based swap often will have an ongoing obligation to exchange cash flows over the life of the agreement. In light of this attribute, some market participants have expressed the view that they have “counterparties” rather than “customers” in the context of their swap activities.

It also is necessary to use the dealer-trader distinction to interpret the security-based swap dealer definition so that the statutory provisions that will govern security-based swap dealers are applied in an effective and logical way. Those statutory provisions added by the Dodd-Frank Act advance financial responsibility (e.g., the ability to satisfy obligations, and the maintenance of counterparties' funds and assets) associated with security-based swap dealers' activities, [257] other counterparty protections, [258] and the promotion of market efficiency and transparency. [259] As a whole, the relevant statutory provisions suggest that we should apply the dealer-trader distinction to interpret the security-based swap dealer definition in a way that identifies those persons for which regulation is warranted either: (i) Due to the nature of their interactions with counterparties; [260] or (ii) to promote market stability and transparency, in light of the role those persons occupy within the security-based swap markets. [261]

b. Principles for Applying the Dealer-Trader Distinction to Security-Based Swap Activity

In light of the statutory security-based swap dealer definition, statutory provisions applicable to security-based swap dealers and market characteristics addressed above, the Commissions believe that the factors set forth below are relevant for identifying security-based swap dealers and for distinguishing those dealers from other market participants. This guidance seeks to address commenter requests that we further clarify the scope of the security-based swap dealer definition, and the Commissions believe that these factors provide appropriate guidance without being inflexible or allowing the opportunity for evasion that may accompany a bright-line test. At the same time, the determination of whether a person is acting as a security-based swap dealer ultimately depends on the relevant facts and circumstances. In light of the overall context in which a person's activity occurs, the absence of one or more of these factors does not necessitate the conclusion that a person is not a security-based swap dealer. [262]

  • Providing liquidity to market professionals or other persons in connection with security-based swaps. A market participant might manifest this indication of dealer activity by accommodating demand or facilitating interest expressed by other market participants, [263] holding itself out as willing to enter into security-based swaps, being known in the industry as being available to accommodate demand for security-based swaps, or maintaining a sales force in connection with security-based swap activities. [264]
  • Seeking to profit by providing liquidity in connection with security-based swaps. A market participant may manifest this indication of security-based swap dealer activity—which is consistent with the definition's “regular business” requirement—by seeking compensation in connection with providing liquidity involving security-based swaps (e.g., by seeking a spread, fees or other compensation not attributable to changes in the value of the security-based swap). [265] The Commissions do not believe that this necessarily requires that a person be available to take either side of the market at any time, or that a person continuously engage in this type of activity, to be a security-based swap dealer. Although one commenter expressed the view that the security-based swap dealer definition requires that a person be consistently available to take either side of the market, [266] in our view such an approach would be underinclusive. [267]
  • Providing advice in connection with security-based swaps or structuring security-based swaps. Advising a counterparty as to how to use security-based swaps to meet the counterparty's hedging goals, or structuring security-based swaps on behalf of a counterparty, also would indicate security-based swap dealing activity. It particularly is important that persons engaged in those activities are appropriately regulated so that their counterparties will receive the protections afforded by certain of the statutory business conduct rules (e.g., special entity requirements and communication requirements) [268] applicable to security-based swap dealers. [269] The Commissions recognize commenter concerns that end-users may also develop new types of security-based swaps, [270] but also recognize that the activities of end-users related to the structuring of security-based swaps for purposes of hedging commercial risk are appreciably different than being in the business of structuring security-based swaps on behalf of a counterparty.
  • Presence of regular clientele and actively soliciting clients. These dealer-trader factors would reasonably appear to be applicable in the security-based swap context, just as they are applicable in the context of other types of securities, as indicia of a business model that seeks to profit by providing liquidity. The Commissions are mindful that some industry participants have highlighted a distinction between “counterparties” and “customers” in connection with swaps, and have suggested that they have no “customers” in the swap context. We do not believe such points of nomenclature are significant for purposes of identifying security-based swap dealers, however. [271]
  • Use of inter-dealer brokers. As with activities involving other types of securities, the Commissions would expect that a person's use of an inter-dealer broker in connection with security-based swap activities to be an indication of the person's status as a dealer.
  • Acting as a market maker on an organized security-based swap exchange or trading system. Acting in a market maker capacity on an organized exchange or trading system for security-based swaps would indicate that the person is acting as a dealer. [272] While the Commissions recognize that some commenters have expressed the view that persons who solely enter into security-based swaps on an organized security-based swap exchange or trading system should not be regulated as security-based swap dealers, [273] in our view such an approach would be contrary to the express language of the definition. This is not to say, of course, that the presence of an organized exchange or trading system is a prerequisite to being a market maker for purposes of the security-based swap dealer definition. [274] Moreover, acting as a market maker is not a prerequisite to being a security-based swap dealer. [275] On the other hand, being a member of an organized exchange or trading system for purposes of trading security-based swaps does not necessarily by itself make a person a security-based swap dealer. [276]

As with the current application of the dealer-trader distinction to the Exchange Act “dealer” definition, the question of whether a person is acting as a security-based swap dealer ultimately will turn upon the relevant facts and circumstances, as informed by these criteria.

c. Additional Interpretive Issues

Activity by hedgers. As noted above, a number of commenters raised concerns that an overbroad “security-based swap dealer” definition would inappropriately encompass persons using security-based swaps for hedging purposes. [277] As we stated in the Proposing Release, however, under the dealer-trader distinction the Commissions would expect persons that use security-based swaps to hedge their business risks, absent other activity, likely would not be dealers. [278] We maintain that view. In other words, to the extent that a person engages in security-based swap activity to hedge commercial risk, or otherwise to hedge risks unrelated to activities that constitute dealing under the dealer-trader distinction (particularly activities that have the business purpose of seeking to profit by providing liquidity in connection with security-based swaps), the Commissions would not expect those hedging transactions to lead a person to be a security-based swap dealer. [279] Of course, to the extent a person engages in dealing activities involving security-based swaps, the presence of offsetting positions that hedge those dealing activities would not excuse the requirement that the person register as a security-based swap dealer. [280]

No predominance test. As discussed in the Proposing Release, the Commissions do not believe that the security-based swap dealer analysis should appropriately turn upon whether a person's dealing activity constitutes that person's sole or predominant business. The separate de minimis exemption, however, may have the effect of excusing from dealer regulation those persons whose security-based swap dealing activities are relatively modest.

Presence or absence of a customer relationship. Although commenters have expressed the view that a person that engages in security-based swap activities on an organized market should not be deemed to be a dealer unless it engages in those activities with customers, [281] we do not agree. It is true that having a customer relationship can illustrate a business model of seeking to profit by providing liquidity, and thus provide one basis for concluding that a person is acting as a security-based swap dealer. Nonetheless, the presence of market making terminology within the definition is inconsistent with the view that a security-based swap dealer must have “customers.” Also, Title VII requirements applicable to security-based swap dealers address interests apart from customer protection. [282] Accordingly, to the extent that a person regularly enters into security-based swaps with a view toward profiting by providing liquidity—rather than by taking directional positions—that person may be a security-based swap dealer regardless of whether it views itself as maintaining a “customer” relationship with its counterparties. [283]

Criteria associated with “holding self out” as a dealer or being “commonly known in the trade” as a security-based swap dealer. The Proposing Release articulated a number of activities that could satisfy the definition's tests for a person “holding itself out” as a dealer or being “commonly known in the trade” as a dealer. [284] Several commenters criticized those proposed criteria, largely on the grounds that those criteria would inappropriately encompass end-users who seek to use security-based swaps for hedging purposes, or otherwise would be overbroad or irrelevant. [285] The Commissions recognize the significance of the concerns those commenters raised, and agree that these activities need to be considered within the context of whether a person engages in those activities with the purpose of facilitating dealing activity. While we do not believe that any of those activities by themselves would necessarily indicate that a person is acting as a security-based swap dealer, under certain circumstances they may serve as an indicia of a business purpose of seeking to profit by providing liquidity in connection with security-based swaps. [286]

6. Requests for Exclusions From the Dealer Definitions

Certain commenters have sought to exclude entire categories of persons from the dealer definitions, notwithstanding that some persons in those categories may engage in the activities set forth in the statutory definition (as further defined by the Commissions). [287] The final rules nonetheless do not incorporate categorical exclusions of persons from the dealer definitions because the statutory definitions provide that “any person” who engages in the activities enumerated in the definitions is covered by the dealer definitions, unless the person's activities fall within one of the statutory exceptions. [288] In this regard, it is significant that the exceptions in the dealer definitions depend on whether a person engages in certain types of swap or security-based swap activity, not on other characteristics of the person. That is, the exceptions apply for swaps between an insured depository institution and its customers in connection with originating loans, [289] swaps or security-based swaps entered into not as a part of a regular business, [290] and swap or security-based swap dealing that is below a de minimis level. [291] The Dodd-Frank Act does not exclude any category of persons from the coverage of the dealer definitions; rather, it excludes certain activities from the dealer analysis.

Given that the statutory dealer definitions focus on a person's activity, the Commissions believe that it is appropriate to determine whether a person meets any of the tests set forth in those statutory definitions, and thus is acting as a swap dealer or security-based swap dealer, on a case-by-case basis reflecting the applicable facts and circumstances. [292] If a person's swap or security-based swap activities are of a nature to be covered by the statutory definitions, and those activities are not otherwise excluded, then the person is covered by the definitions. The contrary is equally true—a person who is not engaged in activities covered by the statutory definitions, or whose activities are excluded from the definition, is not covered by the definitions. [293] The per se exclusions requested by the commenters have no foundation in the statutory text, and have the potential to lead to arbitrary line drawing that may result in disparate regulatory treatment and inappropriate competitive advantages. [294]

The final rules particularly do not include any exclusions for aggregators of swaps or other persons that use swaps in connection with the physical commodity markets, including swaps in connection with the generation, transmission and distribution of electricity. It is likely, though, that a significant portion of the financial instruments used for risk management by such persons are forward contracts in nonfinancial commodities that are excluded from the definition of the term “swap.” [295] Such forward contracts are not relevant in determining whether a person is a swap dealer.

B. “Swap Dealer” Exclusion for Swaps in Connection With Originating a Loan

1. Proposed Approach

The statutory definition of the term “swap dealer” excludes an insured depository institution (“IDI”) “to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.” [296] This exclusion does not appear in the definition of the term “security-based swap dealer.”

Proposed CFTC Regulation § 1.3(ggg)(5) would implement this statutory exclusion by providing that an IDI's swaps with a customer in connection with originating a loan to that customer are disregarded in determining if the IDI is a swap dealer. In order to prevent evasion, the proposed rule further provided that the statutory exclusion does not apply where the purpose of the swap is not linked to the financial terms of the loan; the IDI enters into a “sham” loan; or the purported “loan” is actually a synthetic loan such as a loan credit default swap or loan total return swap.

1. Commenters' Views

Nearly all the commenters on this issue were IDIs seeking a broad interpretation of the exclusion. The commenters addressed four primary issues: (i) The type of swaps that should be covered by the exclusion; (ii) the time period during which parties would be required to enter into the swap in order for the swap to be considered to be “in connection with originating a loan;” (iii) which transactions should be deemed to be “loans” for purposes of the exclusion; and (iv) which entities should be included within the definition of IDI.

First, regarding the type of swap that should be covered by the exclusion, as proposed, § 1.3(ggg)(5) would require that the rate, asset, liability or other notional item underlying the swap be, or be directly related to, a financial term of the loan (such as the loan's principal amount, duration, rate of interest or currency). Some commenters agreed with the principle of limiting the exclusion to swaps that are connected to the financial terms of the loan, stating that the exclusion should cover any swap between a borrower and the lending IDI, so long as the swap's notional amount is no greater than the loan amount, the swap's duration is no longer than the loan's duration, and the swap's index and payment dates match the index and payment dates of the loan. [297] Another commenter, agreeing with the proposed approach, said that there is no basis to extend the loan origination exclusion to swaps related to the borrower's business risks, as opposed to the financial terms of the loan. [298]

Other commenters, though, said that this limitation to swaps connected to the financial terms of the loan was inappropriate or inconsistent with the Dodd-Frank Act, and that any swap required by the loan agreement or required by the IDI as a matter of prudent lending should be covered by the exclusion. [299] Some of the commenters arguing for the broader exclusion emphasized that the exclusion should be available for any swap with the lending IDI which reduces the borrower's risks, such as a commodity swap the borrower uses for hedging, because reduction of commodity price risks faced by the borrower also reduces the risk that the loan will not be repaid to the IDI. [300] Commenters said that if the exclusion does not apply to swaps hedging the borrower's commodity price risks, then only IDIs that are able to create a separately capitalized affiliate will be able to offer commodity swaps (because section 716 of the Dodd-Frank Act limits the ability of IDIs to offer commodity swaps), thereby reducing the availability of commodity swaps to borrowers that are smaller companies. [301]

Second, regarding timing, the proposed rule requested comment on whether this exclusion should apply only to swaps that are entered into contemporaneously with the IDI's origination of the loan (and if so, how “contemporaneously” should be defined for this purpose), or whether this exclusion also should apply to swaps entered into during part or all of the duration of the loan. In response, commenters said that the exclusion should apply to swaps entered into in anticipation of a loan or at any time during the loan term. [302] Commenters said that application of the exclusion throughout the duration of the loan would give IDIs and borrowers flexibility as to when to fix interest rates in fixed/floating swaps relating to loans and would allow borrowers to make other hedging decisions over a longer time period. [303] Commenters also said that loans such as construction loans, equipment loans and committed loan facilities may allow for draws of loan principal over an extended period of time, and that swaps entered into by the borrower and lending IDI through the course of such a loan should be covered by the exclusion. [304]

Third, as to which transactions should be deemed “loans” for purposes of the exclusion, the proposal said that the exclusion should be available in connection with all transactions by which an IDI is a source of funds to a borrower, including, for example, loan syndications, participations and refinancings. Commenters agreed that the exclusion should be available for IDIs that are in a loan syndicate, purchasers of a loan, assignees of a loan or participants in a loan. [305] On loan syndications and participations in particular, one commenter said that the exclusion should be available even if the notional amount of the swap is more than the amount of the loan tranche assigned to the IDI, so long as the swap notional amount is not more than the entire amount of the loan. [306] Another commenter said that the exclusion should not be available if the IDI's participation in the loan drops below a minimum level (such as 20 percent) because such use of the exclusion by minimally-participating IDIs would invite abuse. [307]

Some commenters said that other types of transactions also should be treated as “loans” for purposes of the exclusion. The transactions cited by commenters in this regard include leases, letters of credit, financings documented as sales of financial assets, bank qualified tax exempt loans and bonds that are credit enhanced by an IDI. [308] Other commenters said the exclusion should apply where entities related to an IDI provide financing, such as loans or financial asset purchases by bank-sponsored commercial paper conduits where the IDI provides committed liquidity, [309] and transactions where a special purpose entity formed by an IDI is the source of financing and enters into the swap. [310] Some commenters said the exclusion should encompass all transactions where an IDI facilitates a financing, [311] or all extensions of credit by an IDI, [312] or all transactions where an IDI provides risk mitigation to a borrower. [313]

Fourth, with respect to the types of financial institutions that are eligible for the loan origination exclusion, three commenters said that IDIs, for purposes of this exclusion, encompass more than banks or savings associations with federally-insured deposits. The Farm Credit Council said the exclusion should be extended to Farm Credit System institutions because one of these institutions enters into interest rate swaps with borrowing customers identical in function to those offered by commercial banks and savings associations in connection with loans, and the institutions are subject to similar regulatory requirements and covered by a similar insurance regime. [314] Another commenter said that the exclusion should be extended to other regulated financial institutions, such as insurers, so as not to create an unlevel playing field. [315] And the Federal Home Loan Banks said that the exclusion should be available to them because they are subject to similar regulatory oversight and capital standards and engage in a similar function of extending credit as do commercial banks and savings associations. [316] In addition, some commenters said the exclusion should be broadly construed as a general matter, to encourage competition in the swap market between smaller and larger banks and to increase borrowers' choice among potential swap providers. [317]

Two commenters asked for clarification of the following technical points in the proposed rule: (i) Whether a swap would be covered by the exclusion even if it does not hedge all the risks under the loan, (ii) whether a swap that is within the exclusion could continue to be treated as covered by the exclusion by an IDI if the IDI transfers the loan, and (iii) whether an IDI should count swaps covered by the exclusion in determining if its dealing activity is above the de minimis thresholds. [318] Another commenter asked whether an IDI with swaps that are covered by the exclusion could be a swap dealer based on other dealing activity. [319] And others asked whether the exclusion would cover swaps used by an IDI to hedge its risks arising from a loan (i.e., a swap which the IDI enters into with a party other than the loan borrower). [320]

3. Final Rule

The CFTC believes that the extent of this exclusion should be determined by the language of the statutory definition, which relates to an IDI that “offers to enter into a swap with a customer in connection with originating a loan with that customer.” The expansive interpretation of the exclusion advanced by some commenters, however, would read the statute to exclude almost any swap that an IDI enters into with a loan customer. That is not the exclusion that was enacted. Instead, we interpret the statutory phrase “enter into a swap with a customer in connection with originating a loan with that customer” to mean that the swap is directly connected to the IDI's process of originating the loan to the customer.

Because of the statute's direct reference to “originating” the loan, it would be inappropriate to construe the exclusion as applying to all swaps entered into between an IDI and a borrower at any time during the duration of the loan. If this were the intended scope of the statutory exclusion, there would be no reason for the text to focus on swaps in connection with “originating” a loan. The CFTC recognizes the concern expressed by commenters that: (i) there be flexibility regarding when the IDI and borrower enter into a swap relating to a loan, and (ii) the expectation when an IDI originates a loan with a customer is often that the customer will enter into a swap with the IDI when there is a subsequent advance, or a draw, of principal on the loan. We do not believe, however, that the statutory term “origination” can reasonably be stretched to cover the entire term of every loan that an IDI makes to its customers. At some point, the temporal distance renders the link to loan origination too attenuated, and the risk of evasion too great, to support the exclusion. In order to balance these competing and conflicting considerations, the final rule applies the exclusion to any swap that otherwise meets the terms of the exclusion and is entered into no more than 90 days before or 180 days after the date of execution of the loan agreement, or no more than 90 days before or 180 days after the date of any transfer of principal to the borrower from the IDI (e.g., a draw of principal) pursuant to the loan, so long as the aggregate notional amount of the swaps in connection with the financial terms of the loan at any time is no more than the aggregate amount of the borrowings under the loan at that time. [321]

Since a loan involves the repayment of funds to the IDI on particular terms, a swap that relates to those terms of repayment should be covered by the exclusion. In addition, we recognize that, as stated by commenters, requirements in an IDI's loan underwriting criteria relating to the borrower's financial stability are an important part of ensuring that loans are repaid. [322] Therefore, the final rule modifies the proposed rule to provide that the exclusion applies to swaps between an IDI and a loan borrower that are connected to the financial terms of the loan, such as, for example, the loan's duration, interest rate, currency or principal amount, or that are required under the IDI's loan underwriting criteria to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business. [323] The first category of swaps generally serve to transform the financial terms of a loan for purposes of adjusting the borrower's exposure to certain risks directly related to the loan itself, such as risks arising from changes in interest rates or currency exchange rates. The second category of swaps mitigate risks faced by both the borrower and the lender, by reducing risks that the loan will not be repaid. Thus, both types of swaps are directly related to repayment of the loan. Although some commenters said that this exclusion should also apply to other types of swaps, we believe it would be inappropriate to construe this exclusion as encompassing all swaps that are connected to a borrower's other business activities, even if the loan agreement requires that the borrower enter into such swaps or otherwise refers to them. [324] In contrast to a swap that transforms the financial terms of a loan or is required by the IDI's loan underwriting criteria to reduce the borrower's commodity price risks, other types of swaps serve a more general risk management purposes by reducing other risks related to the borrower or the loan. If the purpose of the exclusion were to cover the broad range of swaps cited by some commenters (such as all swaps reducing a borrower's business risks), then the terms of the statute limiting the exclusion to swaps that are “in connection with originating a loan with that customer” would be superfluous. [325] To give effect to the statutory text, the exclusion is limited to a swap that is connected to the financial terms of the loan or is required by the IDI's loan underwriting criteria to to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business.

Regarding the types of transactions that will be treated as a “loan” for purposes of the exclusion, courts have defined the term “loan” in other statutory contexts based on the settled meaning of the term under common law. This definition encompasses any contract by which one party transfers a defined quantity of money and the other party agrees to repay the sum transferred at a later date. [326] Rather than examine at this time the many particularized examples of financing transactions cited by some commenters, the term “loan” for purposes of this exclusion should be interpreted in accordance with this settled legal meaning. [327]

As stated in the proposed rule, this exclusion is available to all IDIs that are a source of a transfer of money to a borrower pursuant to a loan. The final rule adopts provisions from the proposed rule that the exclusion is available to an IDI that is a source of money by being part of a loan syndicate, being an assignee of a loan, obtaining a participation in a loan, or purchasing a loan. [328] However, the proposed rule did not state explicitly how the notional amount of a swap subject to the exclusion must relate to the amount of money provided by an IDI that is in a loan syndicate or is an assignee of, participant in or purchaser of a loan. In this regard, some commenters said that a borrower and the IDIs in a lending syndicate need flexibility to allocate responsibility for the swap(s) related to the loan as they may agree. [329] We believe that, to allow for this flexibility, the exclusion may apply to a swap (which is otherwise covered by the exclusion) even if the notional amount of the swap is different from the amount of the loan tranche assigned to the IDI. However, we also agree with a commenter that the IDI should have a substantial participation in the loan. [330] The requirement of substantial participation would prevent an IDI from applying the exclusion where the IDI makes minimal lending commitments in multiple loan syndicates where it offers swaps, causing its swap activity to be far out of proportion to its loan activity. [331]

Therefore, the final rule includes a provision that the exclusion may apply regardless of whether the notional amount of the swap is the same as the amount of the loan, but only if the IDI is the sole source of funds under the loan or is committed to be, under the applicable loan agreements, the source of at least 10 percent of the maximum principal amount under the loan. [332] If the IDI does not meet this 10 percent threshold, the final rule provides that the exclusion may apply only if the aggregate notional amount of all the IDI's swaps with the customer related to the financial terms of the loan is no more than the amount lent by the IDI to the customer. [333] We also note that, in all cases, application of the exclusion requires that the aggregate notional amount of all swaps entered into by the borrower with any person in connection with the financial terms of the loan at any time is not more than the aggregate principal amount outstanding under the loan at that time. [334]

We also reiterate the interpretation in the Proposing Release that the word “offer” in this exclusion includes scenarios where the IDI requires the customer to enter into a swap, or where the customer asks the IDI to enter into a swap, specifically in connection with a loan made by that IDI.

We also continue to emphasize, as stated in the Proposing Release, that the statutory language of the exclusion limits its availability to only IDIs as defined in the statute. Regarding some commenters' statements about the competitive effect of this interpretation of the term “insured depository institution,” we believe that the scope of application of the swap dealer definition to various entities should be treated in the de minimis exception, which is available to all persons.

In order to provide clarification in response to certain technical questions raised by commenters, we note that whether a swap hedges all of the risk, or only some of the risk, of a loan is not relevant to application of the exclusion. Nor is it relevant to the exclusion if the IDI later transfers or terminates the loan in connection with which the swap was entered into, so long as the swap otherwise qualifies for the exclusion and the loan was originated in good faith and was not a sham. [335] Further, swaps that are covered by the exclusion should not be considered in determining if an IDI exceeds the de minimis level of swap dealing activity, because the statute provides that swaps covered by the exclusion should not be considered in determining if an IDI is a swap dealer, and the de minimis exception provides that it considers the “quantity of [a person's] swap dealing.” [336] The application of the exclusion to swaps entered into by an IDI in connection with the origination of loans, however, does not mean that the IDI could not be a swap dealer because of other of the IDI's activities that constitute swap dealing. Regarding swaps used by an IDI to hedge or lay off its risks arising from a loan, we do not believe it is appropriate to treat such swaps as covered by the exclusion, because the statute explicitly limits the exclusion to swaps “with a customer,” which such hedging swaps are not. However, a swap that an IDI enters into for the purpose of hedging or laying off the risk of a swap that is covered by the IDI exclusion will not be considered in the de minimis determination, or otherwise in evaluating whether the IDI is covered by the swap dealer definition. [337]

Last, we believe it is appropriate to require that an IDI claiming the exclusion report its swaps that are covered by the exclusion to a swap data repository (“SDR”). This requirement is consistent with the prevailing practice that IDIs handle the documentation of loans made to borrowers, and will provide for consistent reporting of swaps that are covered by the exclusion, thereby allowing the CFTC and other regulators to monitor the use of the exclusion.

In sum, the final rule balances the need for flexibility in response to existing lending practices, consistent with the constraints imposed by the statutory text as enacted, against the risk of establishing a gap in the regulatory framework enacted in Title VII. [338] It provides that the exclusion may be claimed by a person that meets the following conditions: (i) The person is an IDI; (ii) the IDI enters into a swap with the borrower that does not extend beyond the termination of the loan; (iii) the swap is connected to the financial terms of the loan or is required by the IDI's loan underwriting criteria to to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business; (iv) the loan is within the common law meaning of “loan” and it is not a sham or a synthetic loan; (v) the IDI is the source of money to the borrower in connection with the loan either directly, or (so long as the IDI is the source of at least 10 percent of the entire amount of the loan) through syndication, participation, assignment, purchase, refinancing or otherwise; (vi) the IDI enters into the swap with the borrower within 90 days before or 180 days after the date the execution of the loan agreement, or within 90 days before or 180 days after any transfer of principal to the borrower from the IDI pursuant to the loan; (vii) the aggregate notional amount of all swaps entered into by the borrower with all persons in connection with the financial terms of the loan at any time is not more than the aggregate amount of the borrowings under the loan at that time; and (viii) the IDI agrees to report the swap to an SDR.

An IDI that enters into swaps that do not meet these conditions, and thus do not qualify for the statutory exclusion, is not necessarily required to register as a swap dealer. Rather, the IDI would apply the statutory definition and the provisions of the rule (taking into account the applicable interpretive guidance set forth in this Adopting Release), solely with respect to its swaps that are not subject to the IDI exclusion, in order to determine whether it is engaged in swap dealing activity that exceeds the de minimis threshold.

C. Application of Dealer Definitions to Legal Persons and to Inter-Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views

In the Proposing Release, the Commissions preliminarily concluded that designation as a dealer would apply on an entity-level basis (rather than to a trading desk or other business unit that is not organized as a separate legal person), and that an affiliated group of legal persons could include more than one dealer. [339] The Proposing Release also stated that the dealer analysis should consider the economic reality of swaps and security-based swaps between affiliates, and preliminarily noted that swaps or security-based swaps “between persons under common control may not involve the interaction with unaffiliated persons that we believe is a hallmark of the elements of the definitions that refer to holding oneself out as a dealer or being commonly known as a dealer.” [340]

Commenters supported the view that swaps and security-based swaps among affiliates should be excluded from the dealer analysis. [341] A number of commenters took the view that the dealer definitions should not apply when there is common control between counterparties, or when common control is combined with the consolidation of financial statements. [342] Some commenters suggested that this interpretation regarding the scope of the dealer definitions should incorporate concepts of affiliation that are found in other statutory and regulatory provisions. [343] Several commenters also opposed the suggestion (raised as part of the Proposing Release's request for comments) that this interpretation be limited to transactions among wholly owned subsidiaries. [344]

2. Final Interpretation and Rule

a. Application to Legal Persons

Consistent with the Proposing Release, the Commissions interpret “person” as used in the swap dealer and security-based swap dealer definitions to refer to a particular legal person. Accordingly, the dealer definitions will apply to the particular legal person performing the dealing activity, even if that person's dealing activity is limited to a trading desk or discrete business unit, [345] unless the person is able to take advantage of a limited designation as a dealer. [346]

b. Application to Inter-Affiliate Swaps and Security-Based Swaps

The final rules codify exclusions from the dealer definitions for a person's swap or security-based swap activities with certain affiliates. [347] These rules are consistent with the Proposing Release's recognition of the need to consider the economic reality of any swaps or security-based swaps that a person enters into with affiliates. Market participants may enter into such inter-affiliate swaps or security-based swaps for a variety of purposes, such as to allocate risk within a corporate group or to transfer risks within a corporate group to a central hedging or treasury entity.

Under the final rules, the dealer analysis will not apply to swaps and security-based swaps between majority-owned affiliates. [348] When the economic interests of those affiliates are aligned adequately—as would be found in the case of majority-ownership—such swaps and security-based swaps serve to allocate or transfer risks within an affiliated group, rather than to move those risks out of the group to an unaffiliated third party. For this reason, and as contemplated by the Proposing Release, [349] we do not believe that such swaps and security-based swaps involve the interaction with unaffiliated persons to which dealer regulation is intended to apply.

The standard in the final rules differs from the standard suggested by the Proposing Release, which alluded to affiliates as legal persons under “common control.” This change is based on our further consideration of the issue, including consideration of comments that an inter-affiliate exclusion should be available when common control is combined with the consolidation of financial statements. Although we are not including a requirement that financial statements be consolidated—as we do not believe that the scope of this exclusion should be exposed to the risk of future changes in accounting standards—in our view a majority ownership standard is generally consistent with consolidation under GAAP. [350] Absent majority ownership, we cannot be confident that there would be an alignment of economic interests that is sufficient to eliminate the concerns that underpin dealer regulation.

In taking this approach, we have also considered alternatives suggested by commenters. For example, while one commenter suggested that we adopt a definition of “affiliate” as used in the securities laws, [351] we believe that such an approach would be too broad for the purpose of this exclusion from dealing activity, given that common control by itself does not ensure that two entities' economic interests are sufficiently aligned. [352]

c. Application to Cooperatives

Similar considerations apply, in certain situations, to cooperative entities that enter into swaps with their members in order to allocate risk between the members and the cooperative. Commenters identified two general types of such cooperatives—“cooperative associations of producers” as defined in section 1a(14) of the CEA [353] and cooperative financial entities such as Farm Credit System institutions and Federal Home Loan Banks. [354] As is the case for affiliated groups of corporate entities, we believe that when one of these cooperatives enters into a swap with one of its members, [355] the swap serves to allocate or transfer risks within an affiliated group, rather than to move those risks from the group to an unaffiliated third party, so long as the cooperative adheres to certain risk management practices.

Accordingly, the final rules specifically provide that the dealer analysis excludes swaps between a cooperative and its members, so long as the swaps in question are reported to the relevant SDR by the cooperative and are subject to policies and procedures of the cooperative which ensure that it monitors and manages the risk of such swaps. [356] The final rules define the term “cooperative” to include cooperative associations of producers and any entity chartered under Federal law as a cooperative and predominantly engaged in activities that are financial in nature. [357] The cooperatives covered by this relief are subject to provisions of Federal law providing for their cooperative purpose. Cooperative associations of producers have been recognized since the passage of the Capper-Volstead Act as being permitted to engage in certain cooperative activities without violating antitrust laws. [358] Cooperative financial institutions such as the Farm Credit System institutions and Federal Home Loan Banks are chartered under Federal laws that limit their membership and require that they serve certain public purposes. [359]

We are aware that other persons commented that their swap activities should be excluded from the dealer analysis because they use swaps in connection with a cooperative or non-profit purpose, or because they aggregate demand for swaps arising from numerous small entities. [360] However, the key distinction drawn in granting this relief is that cooperatives covered by the exclusion enter into swaps with their members in order to allocate risk between the members and the cooperative. By contrast, the other entities noted above enter into swaps with unaffiliated parties in order to transfer risks between unaffiliated parties. [361] As noted above, the Commissions believe that the contemplated scope of the statutory definitions does not include instances where a person's swap activities transfer risk within an affiliated group, but does extend to activities that create legal relationships that transfer risk between unaffiliated parties. Thus, it is appropriate that the dealer analysis exclude swaps between a cooperative and its members, but such analysis should include swaps between a cooperative or other aggregator and unaffiliated persons.

D. De Minimis Exception

1. Proposed Approach

The Dodd-Frank Act's definitions of “swap dealer” and “security-based swap dealer” require that the Commissions exempt from dealer designation any entity “that engages in a de minimis quantity” of dealing “in connection with transactions with or on behalf of customers.” The statutory definitions further require the Commissions to “promulgate regulations to establish factors with respect to the making of any determination to exempt.” [362]

In the Proposing Release, we preliminarily concluded that the de minimis exception “should be interpreted to address amounts of dealing activity that are sufficiently small that they do not warrant registration to address concerns implicated by the regulations governing swap dealers and security-based swap dealers. In other words, the exception should apply only when an entity's dealing activity is so minimal that applying dealer regulations to the entity would not be warranted.” [363] In taking this view, we rejected the suggestion that the de minimis exception should compare a person's swap or security-based swap dealing activities to the person's non-dealing activities. [364]

At the same time, we recognized that this proposed approach did not appear to “readily translate into objective criteria.” We further recognized that a range of alternative approaches may be reasonable, and we solicited comment as to what factors should be used to implement the exception. [365]

The proposed de minimis exception was comprised of three factors, all of which a person would have had to satisfy to avail itself of the exception. [366] The first proposed factor would have limited the aggregate effective amount, measured on a gross basis, of the swaps or security-based swaps that a person entered into over the prior 12 months in connection with its dealing activities to $100 million [367] (or $25 million with regard to counterparties that are “special entities”). [368]

The second proposed factor would have limited a person's swap or security-based swap dealing activity to no more than 15 counterparties over the prior 12 months (while counting counterparties that are members of an affiliated group as one counterparty for these purposes). The final proposed factor would have limited a person's dealing activity to no more than 20 swaps or security-based swaps over the prior 12 months (without counting certain amendments as new swaps or security-based swaps).

2. Commenters' Views

a. Basis for the Exception

Some commenters sought to link the de minimis exception to systemic risk criteria by taking the position that a person should have to register as a dealer only if its dealing activities pose systemic significance. [369] One commenter specifically objected to the position in the Proposing Release that the de minimis exception should take into account customer protection principles. [370] On the other hand, one commenter supported the rejection of a risk-based de minimis test. [371]

Some commenters argued that the de minimis test should account for proportionality criteria that would excuse entities whose dealing activity is relatively minor compared to their other activities. [372]

b. Significance of “Customer” Language

One commenter took the position that the language within the de minimis exception that specifically referred to “transactions with or on behalf of customers” meant that the exception should be available only for persons who limit their swaps or security-based swaps to those that are entered into with or on behalf of customers. [373] Other commenters posited the opposite view that the “customer” language should be read to mean that a person's dealing activities with counterparties other than customers may be disregarded for purposes of the exception (i.e., non-customer transactions would not count against the de minimis thresholds). [374] Some commenters argued that transactions entered into in a fiduciary capacity should be disregarded for purposes of the exception. [375] One commenter questioned the proposal's use of the term “counterparty” in lieu of the statutory term “customer.” [376]

c. Proposed Tests and Thresholds

Commenters criticized the proposed de minimis thresholds in a variety of ways. These included arguments that the proposed thresholds were inappropriately low, [377] would harm end-users by reducing the number of entities willing to enter into low-value swaps and security-based swaps, [378] would be unjustified on a cost-benefit basis, [379] and were disproportionately low compared to the activities of recognized dealers. [380] Other commenters said the de minimis thresholds should be set at a level to allow entities to engage in a meaningful amount of customer-facing swaps or security-based swaps without being required to register as dealers. [381]

A number of commenters particularly criticized the proposed notional threshold, with some commenters suggesting that the threshold should be based on a percentage of the total swap market [382] or some other fixed value, [383] or arguing in favor of an exposure-based threshold in lieu of a notional threshold. [384] Other commenters said that the aggregate notional amount of swaps is not a meaningful measure of an entity's dealing activity. [385] A few commenters supported the proposed notional threshold. [386]

Some commenters argued against basing the de minimis exception on the number of a person's swaps or security-based swaps or the number of a person's counterparties, [387] or supported increasing those thresholds above the proposed standard. [388] Commenters also suggested a variety of other alternatives to the proposed tests. [389]

d. Additional Issues

Some commenters emphasized the need to provide protections in connection with “special entities.” [390] Certain commenters sought to identify problems related to the application of the proposed thresholds in connection with particular types of businesses or markets, [391] or to aggregators or cooperatives. [392] Other commenters suggested that the exception should focus dealer regulation toward “financial” entities. [393] One commenter emphasized the need for the exception to be available when the end-user is a credit union, bank or thrift. [394]

Commenters sought clarification that the de minimis criteria would not apply to transactions for hedging or proprietary trading purposes, [395] or to inter-affiliate transactions. [396]

Commenters also raised issues related to the exception's treatment of the proposed use of a rolling annual period for calculations, [397] the proposed use of “effective notional amounts,” [398] the possibility of adjusting the thresholds over time, [399] how the de minimis tests would apply in the context of affiliated positions, [400] and how the exception would account for swaps or security-based swaps entered into before the definition's effective date. [401]

Some commenters suggested that the de minimis thresholds be set higher initially to provide for efficient use of regulatory resources. [402] One commenter requested clarification that the exception would apply prospectively without regard to dealing activities taken prior to the effectiveness of Title VII. [403] One commenter requested that a person that falls above the de minimis tests be able to take advantage of application and re-evaluation periods akin to those associated with the major participant definitions. [404]

Two commenters expressed support for the proposed self-executing approach of the exception. [405] Some commenters requested clarification that the de minimis exception is independent of the loan origination exclusion in the CEA “swap dealer” definition. [406]

A number of commenters also addressed the application of dealer regulation to non-U.S. entities. While those comments did not specifically address the de minimis exception, the exception may be relevant to addressing these cross-border issues. [407]

One commenter separately addressed the credit default swap data analysis made available by CFTC and SEC staffs. [408] The commenter expressed the view that this data supported the adoption of a de minimis threshold of $100 million or less, particularly focusing on the number of entities that may be excluded under particular thresholds. [409]

3. Final Rules—General Principles for Implementing the De Minimis Exception

a. Balancing Regulatory Goals and Burdens

The Commissions recognize that implementing the de minimis exception requires a careful balancing that considers the regulatory interests that could be undermined by an unduly broad exception as well as those regulatory interests that may be promoted by an appropriately limited exception.

On the one hand, a de minimis exception, by its nature, will eliminate key counterparty protections provided by Title VII for particular users of swaps and security-based swaps. [410] The broader the exception, the greater the loss of protection. [411] Moreover, in determining the scope of the exception, it is important to consider not only the current state of the swap and security-based swap markets, but also to account for how those markets may evolve in the future. This is particularly important because the full implementation of Title VII—including enhancements to pricing transparency and the increased access to central clearing—reasonably may be expected to facilitate new entrants into the swap and security-based swap markets. To the extent that such entrants engage in dealing activity below the de minimis threshold—either for the long term or until their activity surpasses the threshold—the relative amount of unregistered activity within the market may be expected to increase. Accordingly, a higher de minimis threshold may not only result in a certain percentage of unregistered activity being transacted initially, consistent with the current market, but also may result in an even greater proportion of unregistered activity being transacted in the future.

On the other hand, the Commissions also recognize that Congress included a statutorily mandated de minimis exception for certain swap and security-based swap dealing activity, and that an appropriately calibrated de minimis exception has the potential to advance other interests. For example, the de minimis exception may further the interest of regulatory efficiency when the amount of a person's dealing activity is, in the context of the relevant market, limited to an amount that does not warrant registration to address the concerns implicated by government regulation of swap dealers and security-based swap dealers. To advance this interest, it is necessary to consider the benefits to the marketplace associated with the regulation of dealers against the total burdens and potential impacts on competition, capital formation and efficiency associated with that regulation. [412]

In addition, the exception can provide an objective test for persons who engage in some swap or security-based swap activities that, in their view, potentially raise the risk that they would be deemed to be dealers. [413] The exception also may permit persons that are not registered as dealers to accommodate existing clients that have a need for swaps or security-based swaps in conjunction with other financial services or commercial activities, thus avoiding the need for such clients to establish separate relationships with registered dealers, which may have attendant costs. The exception further may promote competition in dealing activity within the swap or security-based swap markets, by helping to allow non-registered persons to commence providing dealing services while avoiding the costs associated with full-fledged dealers. More competition within the market for swaps and security-based swaps may not only decrease the costs for participants in the market, but also may help to decrease systemic risk by lessening the current apparent concentration of dealing activity among a few major market participants. [414]

The statutory requirements that apply to swap dealers and security-based swap dealers include requirements aimed at the protection of customers and counterparties, [415] as discussed above, as well as requirements aimed at helping to promote effective operation and transparency of the swap and security-based swap markets. [416] The overall economic benefits provided by these requirements in large part will depend on the proportion of swaps and security-based swaps that are transacted subject to these requirements. In other words, the greater the dealing activity of a registered dealer, the more significant the resulting increase in market efficiency, [417] and the greater the reduction in risks faced by the entity's customers and counterparties. [418] These benefits can be expected to accrue over the long term and be distributed over the market and its participants as a whole. This is not to say, however, that it would be insignificant for any particular counterparty if its swaps or security-based swaps were to fall outside of the ambit of dealer regulation. For example, a customer or counterparty that is not protected by the business conduct rules applicable to dealers might be more likely to suffer losses associated with entering into an inappropriate or misunderstood swap or security-based swap than if the instrument was transacted pursuant to the business conduct rules applicable to registered dealers.

In contrast to the benefits associated with dealer regulation, many of the burdens of dealer regulation will accrue in the short term and will fall directly on registered dealers. [419] Some of those burdens may be expected to be independent of the amount of an entity's dealing activity (i.e., entities that engage in minimal dealing activity would still be expected to face certain burdens associated with the registration process and the development of compliance and other systems if they are required to register as dealers), while other burdens (e.g., the impact of margin and capital rules applicable to dealers) may be more directly linked to the amount of that entity's dealing activity.

As discussed below, the Commissions have sought to balance the various interests associated with a de minimis exception, as well as the benefits and burdens associated with such an exception, in developing the factors to implement the de minimis exceptions to the “swap dealer” and “security-based swap dealer” definitions.

However, in moving forward with implementing this balancing approach, we recognize that the information that currently is available regarding certain portions of the swap market is limited. Following the full implementation of Title VII, more information will be available to permit us to assess the effectiveness of this balancing for particular markets and to revise the exception as appropriate.

In that context—and in light of the tools currently available to us—we have been influenced, in particular, by comments taking the view that the de minimis factors should take into account the size and unique attributes of the market for swaps and security-based swaps. [420] We believe that factors that exclude entities whose dealing activity is sufficiently modest in light of the total size, concentration and other attributes of the applicable markets can be useful in avoiding the imposition of regulatory burdens on those entities for which dealer regulation would not be expected to contribute significantly to advancing the customer protection, market efficiency and transparency objectives of dealer regulation. The Commissions note, however, that they are not of the general view that the costs of extending regulation to any particular entity must be outweighed by the quantifiable or other benefits to be achieved with respect to that particular entity. The Commissions, rather, analyze the overall benefits and costs of regulation, keeping in mind, as noted above, that the benefits may be distributed, accrue over the long-term, and be difficult to quantify or to measure as easily as certain costs. [421]

b. Specific Factors Implementing the De Minimis Exception

i. Notional Test

Consistent with the proposal, the final rules implementing the de minimis exception take into account the notional amount of an entity's swap or security-based swap positions over the prior 12 months arising from its dealing activity. [422] While the Commissions recognize that notional amounts do not directly measure the exposure or risk associated with a swap or security-based swap position, such measures do reflect the relative amount of an entity's dealing activity. [423] Moreover, although some commenters have posited measures of risk or exposure as alternatives to notional measures, such risk or exposure measures could, to the extent they allow for netting or collateral offsets, potentially allow an unregistered entity to engage in large amounts of swap or security-based swap dealing activity while remaining within the de minimis exception so long as that entity nets or collateralizes its swap or security-based swap positions. Such an outcome could undermine the customer protection and market operation benefits associated with dealer regulation. As with the proposed rules, the notional factor in the final rules is based on the notional positions of an entity over a 12 month period, rather than capping the current notional amount of a position at any time, to better reflect the amount of an entity's current activity.

The final rules, like the proposed rules, include lower notional thresholds for dealing activities in which the counterparty is a “special entity.” [424] This is consistent with the fact that Title VII's requirements applicable to swap dealers and security-based swap dealers provide heightened protection to those types of entities. [425] It is important that the de minimis exception not undermine those statutory protections. [426] Also, consistent with the Proposing Release, these notional standards will be based on “effective notional” amounts when the stated notional amount is leveraged or enhanced by the structure of the swap or security-based swap. [427]

ii. Other Tests From the Proposing Release

The proposed rules limited the number of swaps or security-based swaps that an entity could enter into in a dealing capacity, and the number of an entity's counterparties in a dealing capacity. The final rules do not include those measures. In part, this reflects commenter concerns that a standard based on the number of swaps or security-based swaps or counterparties can produce arbitrary results by giving disproportionate weight to a series of smaller transactions or counterparties. [428]

c. Significance of Statutory “Customer” Language

Consistent with the Proposing Release, the final rules implementing the de minimis exception do not require the presence of any type of defined “customer” relationship.

In adopting these rules the Commissions have considered alternative approaches suggested by commenters, including one commenter's suggestion that the de minimis exception should be available only in connection with swaps or security-based swaps entered into as part of a “customer” relationship. [429] In considering that alternative view, however, we believe that it is significant that the statutory exception lacks terminology such as “existing” or “preexisting” that limits the availability of the exception or otherwise to distinguishes a “customer” relationship from other types of counterparty relationship. Also, while that alternative view could still permit an unregistered person to provide limited dealer services as an accommodation to an existing customer or counterparty, an interpretation that predicates the exception on the presence of a particular type of “customer” relationship would not advance other potential benefits associated with a de minimis exception, including the benefit of providing certainty in connection with the swap or security-based swap activities of end-users. [430] Accordingly, we do not believe that the “customer” reference standing alone provides a sufficient basis to conclude that the exception should only be available if there is an existing relationship of some type, and the final rules neither require that a dealer accommodate the demand of an existing customer nor require the presence of a preexisting relationship for the exception to apply.

We also are not persuaded by the different commenter suggestion that the statutory de minimis exception's “customer” language means that an unregistered dealer should be permitted to engage in unlimited dealing activity so long as its counterparties are not customers. [431] Such an unlimited exception would appear to be contrary to the express language of the statutory exception. In addition, such an approach would lead to the perverse result of discouraging entities from entering into swaps or security-based swaps to facilitate risk management activities of customers (while encouraging other dealing activities), which appears contrary to Title VII's general approach of seeking to limit undue impacts on the swap and security-based swap activities of commercial end-users.

d. Focus on “Dealing” Activity

Some commenters suggested that we clarify that the limitations associated with the de minimis exception apply only in connection with a person's dealing activities, and not to the person's hedging or proprietary trading activities. [432] The Commissions agree that the de minimis exception is intended to permit an unregistered person to engage in a limited amount of dealing activity without regard to the person's non-dealing activity. Thus, to the extent that a particular swap or security-based swap position is not connected to dealing activity under the applicable interpretation of the statutory dealer definition, it will not count against the de minimis thresholds. Conversely, if a swap or security-based swap position is connected to the person's dealing activity, the position will count against those thresholds. [433]

Commenters also requested clarification that the de minimis thresholds do not apply to a person's inter-affiliate swaps and security-based swaps, nor apply to swaps covered by the exclusion for swaps entered into by insured depository institutions in connection with the origination of loans to customers. [434] Consistent with the discussion above, [435] such swaps or security-based swaps do not constitute dealing activity and should not be counted against the de minimis thresholds. Similarly, swaps between a cooperative and its members, as provided in CFTC Regulation § 1.3(ggg)(6)(ii), and swaps entered into for the hedging purpose defined in CFTC Regulation § 1.3(ggg)(6)(iii) should not be counted against the de minimis threshold. [436]

In light of the increased notional thresholds of the final rules, and the resulting opportunity for a person to evasively engage in large amounts of dealing activity if it can multiply those thresholds, the final rules provide that the notional thresholds to the de minimis exception encompass swap and security-based swap dealing positions entered into by an affiliate controlling, controlled by or under common control with the person at issue. [437] This is necessary to prevent persons from avoiding dealer regulation by dividing up dealing activity in excess of the notional thresholds among multiple affiliates. [438]

e. Alternative Approaches We Are Not Following

Certain commenters have suggested alternative approaches to implementing the de minimis exception. While the Commissions have considered those suggested alternatives, we do not believe that they provide the optimal framework for implementing the exception.

For example, some commenters took the position that the de minimis exception should focus dealer regulation on those entities whose dealing activities pose systemic risk, and excuse other dealers from having to register. [439] Such an approach, however, would fail to account for regulatory interests apart from the control of systemic risk that are addressed by dealer regulation, including statutory provisions that protect customers and counterparties in other ways, and that promote effective market operations and transparency. [440]

Some commenters also have suggested that the de minimis exception should subsume a proportionality standard, whereby an entity may be excluded from dealer regulation if its dealing activity comprises only a relatively small portion of its overall activities (or its overall swap or security-based swap activities), or if its dealing activity is “tangential” to its principal business. [441] We are not incorporating that type of approach into the de minimis factors, however, because that approach would not appear to provide a logical way to balance the benefits and burdens of dealer regulation. A proportionality approach could permit a large entity to engage in a significant amount of dealing activity without being subject to dealer regulation, thus undermining the benefits of dealer regulation. Moreover, a proportionality approach could lead to arbitrary results by excusing a large entity from dealer regulation while requiring the registration of a smaller entity that engages in less total dealing activity (if that smaller amount of dealing activity comprises a greater portion of the smaller entity's total activity). [442]

Some commenters also supported the use of non-quantitative standards in connection with the de minimis exception. [443] Although we recognize that such an approach may help us weigh the facts and circumstances associated with a particular person's dealing activity, we believe that it is more appropriate to base the exception on an objective quantitative standard, to allow the exception to be self-executing, and to promote predictability among market participants and the efficient use of regulatory resources. Unlike the overall definitions of “swap dealer” and “security-based swap dealers,” which consider the entirety of a person's activities with respect to swaps, the de minimis exception is only relevant to persons who have determined that they are engaged in swap or security-based swap dealing, and are looking to determine whether the quantity of their dealing activity is de minimis. For this more particular and focused determination, an objective quantitative standard is more appropriate.

Commenters also made various suggestions as to the types of factors and accompanying thresholds that should be used in connection with the de minimis exception. Those suggestions are addressed more specifically below in the specific context of the swap dealer and security-based swap dealer de minimis exceptions.

4. Final Rules—De Minimis Exception to Swap Dealer Definition

a. Overview of the Final Rule

After considering commenters' views, the final rule implementing the de minimis exception caps an entity's dealing activity involving swaps at $3 billion over the prior 12 months. [444] This amount is based on input from commenters and is supported by several rationales, including the estimated size of the domestic swap market, among others.

As noted above, commenters who suggested a fixed notional standard proposed that the standard be set at a level between $200 million and $3.5 billion in notional amount of swaps entered into over a period of twelve months. [445] In considering these comments, we are mindful of the variety of uses of swaps in various markets and therefore it is understandable that various commenters would reach different conclusions regarding the appropriate standard. At the same time, we see value in setting a single standard for all swaps so that there is a “level playing field” for all market participants and so that the standard can be implemented easily without the need to categorize swaps. Considering the written input of the commenters as well as the discussions of the de minimis standard at the Commissions' joint roundtable and numerous meetings with market participants, and the benefits of the regulation of swap dealers (i.e., protection of customers and counterparties, and promotion of the effective operation and transparency of the swap markets), we believe a notional standard at a level of $3 billion appropriately balances the relevant regulatory goals.

As noted above, several commenters suggested that the standard be set at an amount equal to 0.001 percent of the overall domestic market for swaps. The Commissions note, however, that comprehensive information regarding the total size of the domestic swap market is incomplete, with more information available with respect to certain asset classes than others. The CFTC evaluated data regarding one particular type of swap—credit default swaps (“CDS”) based on indices of debt securities known as “index CDS”—that was provided by the SEC. [446] As noted in the CFTC analysis of this data, however, the information is not filtered to reflect activity that would constitute swap dealing under the Dodd-Frank Act, so it is not possible to use the data to draw conclusions regarding any specific entity's status as a swap dealer. [447] The data reflects only activity relating to index CDS, which constitute a very narrow part of the overall swap market, and, as noted in the CFTC analysis, similar data regarding other types of swaps is not available. [448] Subject to these limitations, the data may help evaluate the impact of alternative approaches to implementing the de minimis exception.

One often-cited measure of the market, the Quarterly Report on Bank Trading and Derivatives Activities issued by the OCC (“OCC Quarterly Report”) is both limited, in that it includes only data related to the activities of U.S. bank holding companies, commercial banks and trust companies, and over-inclusive, in that it includes activities related to instruments that are not or may not be included in the final definition of “swap” (including futures, forwards, certain foreign exchange instruments, and certain options) and it includes both swaps and security-based swaps. Nonetheless, the Commissions believe that the available (imperfect) data suggests that a $3 billion notional standard is generally consistent with the commenters' suggestion of basing the standard on a percentage of the overall domestic market for swaps.

The total notional value of $333.1 trillion in “derivatives” stated in the most recent OCC Quarterly Report includes approximately $221.1 trillion in “swaps” and “credit derivatives.” [449] Since some instruments that are security-based swaps are included in this total, [450] the total notional value of swap positions at U.S. bank holding companies, commercial banks and trust companies at the end of the second quarter of 2011 of may be estimated to be somewhat less than $221.1 trillion.

This total notional value is by nature under-inclusive, because it reflects only swap positions at U.S. bank holding companies, commercial banks and trust companies and not the swap positions of other market participants. However, there are also reasons that the information from the OCC Quarterly Report may overstate the notional value of swaps that would be relevant to estimating the size of the domestic swap market for purposes of the de minimis standard. While we believe the data is not sufficiently precise at this time to serve as the sole basis for the notional standard, a standard of $3 billion seems that it is likely generally consistent with 0.001 percent of the domestic swap market that would be relevant to a potential dealer's de minimis swap activity figure. First, the large majority of derivatives in the OCC Quarterly Report (approximately $229 trillion in notional value for commercial banks and trust companies) are derivatives between “dealers” (as defined for the purposes of the report.) [451] Thus, it is likely that a large part of the derivatives in the OCC Quarterly Report reflect transactions between financial institutions that will be swap dealers. It is also notable that approximately $204.6 trillion in notional value of the derivatives (i.e., not only swaps) reported by U.S. commercial banks were interest rate contracts, many of which are swaps entered into by IDIs with customers in connection with the origination of loans which will be excluded from the determination of whether the IDIs are swap dealers. [452] Finally, the OCC Quarterly Report measures swap positions held at a certain point in time, rather than the level of swap activity over a certain time period, again indicating that the figures are broader than those that would be subject to the de minimis figure. Accordingly, it appears that notional amount of the overall domestic market for swaps that actually would be relevant to determining the notional standard, and thus the appropriate basis for the 0.001 percent calculation, may be significantly lower than $331 trillion.

Because there is merit in the 0.001 percent ratio suggested by several commenters, we believe an appropriate balance of the goal of promoting the benefits of regulation (while recognizing the unquantifiable nature of those benefits) against the competing goal of avoiding the imposition of burdens on those entities for which regulation as a dealer would not be associated with achieving those benefits in a significant way, would be reached by setting the notional standard for swaps at a level that is near (taking into account the uncertainties noted above) 0.001 percent of a reasonable estimate of the overall domestic market for all swaps between all counterparties. We believe a $3 billion notional value standard is appropriate taking all these considerations into account.

b. Dealing Activity Involving Special Entities

For swaps in which the counterparty is a special entity, the final rules set a notional standard consistent with the proposal of $25 million over the prior 12 months. [453] The Commissions believe that this notional standard is appropriate in light of the special protections that Title VII affords to special entities. In adopting this threshold, we recognize the serious concerns raised by commenters stating that the de minimis exception should not permit any dealing activities (by persons who are not registered as swap dealers) involving special entities, in light of losses that special entities have incurred in the financial markets. [454] However, the final rule does not fully exclude such dealing activity from the exception, in light of the potential benefits that may arise from a de minimis exception. In this way, the threshold would not completely foreclose the availability of swaps to special entities from unregistered dealers, but the threshold would limit the financial and other risks associated with those positions for a special entity, which would in turn limit the possibility of inappropriately undermining the special protections that Title VII provides to special entities.

c. Phase-in Procedure

The Commissions believe that a phase-in period for the de minimis threshold would facilitate the orderly implementation of Title VII by permitting market participants and the Commissions to familiarize themselves with the application of the swap dealer definition and swap dealer requirements and to consider the information that will be available about the swap market, including real-time public reporting of swap data and information reported to swap data repositories. In addition, a phase-in period would afford the Commissions additional time to study the swap markets as they evolve in the new regulatory framework and allow potential swap dealers that engage in smaller amounts of activity (relative to the current size of the market) additional time to adjust their business practices, while at the same time preserving a focus on the regulation of the largest and most significant swap dealers. The Commissions also recognize that the data informing their current view of the de minimis threshold is based on the markets as they exist today, and that the markets will evolve over the coming years in light of the new regulatory framework and other developments.

We have also considered that there may be some uncertainty regarding the exact level of swap dealing activity, measured in terms of a gross notional amount of swaps, that should be regarded as de minimis. While some quantitative data regarding the usage of swaps is available, there are many aspects of the swap markets for which definitive data is not available. We have also considered comments suggesting that the de minimis thresholds should be set higher initially to provide for efficient use of regulatory resources, [455] or that implementation of the dealer requirements should be phased. [456] For all these reasons, the Commissions believe it is appropriate that the final rules provide for a phase-in period following the effective date during which higher de minimis thresholds would apply.

In particular, during this phase-in period, a person's swap dealing activity over the prior 12 months is capped at a gross notional value of $8 billion. [457] With respect to swaps with special entities, the Commissions believe it is appropriate that the $25 million gross notional value threshold apply during the phase-in period. [458] In light of the available data—and the limitations of that data in predicting how the full implementation of Title VII will affect dealing activity in the swap markets—the Commissions believe that the appropriate threshold for the phase-in period is an annual gross notional level of swap dealing activity of $8 billion or less. In particular, the $8 billion level should still lead to the regulation of persons responsible for the vast majority of dealing activity within the swap markets.

Accordingly, the Commissions believe that while a $3 billion notional threshold reflects an appropriate long-term standard based on the available data, [459] it also is appropriate to allow a degree of latitude in applying the threshold over time in the event that subsequent developments in the markets or the evaluation of new data from swap data reporting facilities suggest that the thresholds should be adjusted. In particular, the implementation of swap data reporting under the Dodd-Frank Act may result in new data that would be useful in confirming the Commissions' determination to establish the $3 billion threshold which applies after the phase-in period.

For these reasons, review of the de minimis exception will comprise an important part of the reports that the CFTC is directing its staff to conduct with regard to the swap dealer definition during the phase-in period. Among other topics, the report should consider market data addressing swap dealing activity over a period of approximately two years, and any resulting changes in swap dealing activity, by dealers above and below the $8 billion phase-in threshold, and above and below the $3 billion level applicable after the phase-in period. The report is required to be completed by the CFTC staff no later than 30 months following the date that a swap data repository first receives swap data under the CFTC's regulations, and the report will be published for public comment. [460] The CFTC will take this report, in conjunction with any public comment on it, into account in weighing further action on the de minimis exception at the end of the phase-in period.

The final rules provide that nine months after publication of its staff report, the CFTC may, in its discretion, either promulgate an order that the phase-in period will end as of the date set forth by the CFTC in that order, or issue for public comment a notice of proposed rulemaking to modify the de minimis threshold, in which case the CFTC would also issue an order establishing the date that the phase-in period will end. [461] The period of nine months provided in the rule is intended to provide the CFTC an opportunity to consider its staff report, public comments on the staff report and any other relevant information.

The CFTC recognizes that the determination of the appropriate de minimis threshold is a significant issue requiring thorough consideration of a variety of regulatory and market factors. At the same time, the CFTC recognizes the need for predictability in how the de minimis exception will apply. Therefore, the final rules include a finality provision, stating that the phase-in period will end no later than five years after the date that a swap data repository first receives swap data under the CFTC's regulations. [462]

Persons who are able to avail themselves of the higher de minimis threshold that applies during the phase-in period will not be required to do so. In particular, a person that is engaged in dealing activity involving swaps in excess of the $3 billion threshold may choose to commence the process for registering as a swap dealer during the phase-in period. [463]

d. CFTC Staff Report

As noted above, the CFTC is directing its staff to report to the CFTC as to whether changes are warranted to the rules implementing the swap dealer definition, including the rule implementing the de minimis exception. We are mindful that following the full implementation of Title VII—which itself is contingent on the implementation of the dealer definition—more data will be available to the CFTC via swap data repositories. We expect that this additional data will assist the CFTC in testing the assumptions and addressing the effects of the final rule we are adopting to implement the de minimis exception. For example, this data should help the CFTC assess, among other things, the nature and amount of unregulated dealing activity that occurs under the $3 billion threshold. The CFTC will make this report available for public comment so that it may benefit from additional input and analysis regarding the swap dealer definition.

By making use of post-implementation data, the staff report (together with public comment on the report) will help the CFTC better evaluate the exception in light of potential market changes resulting from the full implementation of Title VII—including market changes resulting from the de minimis exception itself—as part of determining whether revised de minimis thresholds would be appropriate. The report and public comment thereon will also be taken into consideration by the CFTC in determining what action, if any, to take with respect to the phase-in period associated with the de minimis exception.

The final rules provide, moreover, that the CFTC may change the requirements of the de minimis exception by rule or regulation. [464] Through this mechanism, the CFTC may revisit the rule implementing the exception and potentially change that rule, for example, if data regarding the post-implementation swap market suggests that different de minimis thresholds would be appropriate. [465] In determining whether to revisit the thresholds, the CFTC intends to pay particular attention to whether the de minimis exception results in a swap dealer definition that encompasses too many entities whose activities are not significant enough to warrant full regulation under Title VII, or, alternatively, whether the de minimis exception leads an undue amount of dealing activity to fall outside of the ambit of the Title VII regulatory framework, or leads to inappropriate reductions in counterparty protections (including protections for special entities). The CFTC also intends to pay particular attention to whether alternative approaches would more effectively promote the regulatory goals that may be associated with a de minimis exception.

5. Final Rules—De Minimis Exception to “Security-Based Swap Dealer” Definition

a. Overview of the Final Rule

The final rule implementing the de minimis exception to the “security-based swap dealer” definition has been revised from the proposal in a number of ways. As discussed above, the final rule does not incorporate proposed limits on the number of security-based swaps that a person may enter into in a dealing capacity, or on the number of security-based swap counterparties a person may have when acting in a dealing capacity. [466] Moreover, the provisions of the exception that cap an unregistered person's annual notional dealing activity with counterparties other than “special entities” have been increased from the proposed $100 million threshold. [467] Instead, the final rule caps such dealing activity involving security-based swaps that are credit default swaps—which largely would consist of single-name credit default swaps—at $3 billion in notional amount over the prior 12 months. [468] For other types of security-based swaps (e.g., single-name or narrow-based equity swaps or total return swaps), the exception caps an unregistered person's dealing activity at $150 million in notional amount over the prior 12 months. [469] Also, as addressed below, the final rule provides for phase-in levels in excess of those $3 billion and $150 million thresholds for a certain period of time.

In addition, consistent with the proposal, the final rule caps an unregistered person's security-based swap dealing activity involving counterparties that are “special entities” at $25 million in notional amount over the prior 12 months. [470] The final rule further provides that the SEC may establish alternative methods of determining the scope of the de minimis exception by rule or regulation. [471]

b. Interests Associated With a De Minimis Exception

In developing this final rule, we have sought to balance the interests advanced by the de minimis exception against the protections that would be weakened were the exception applied in an overbroad manner. In making this evaluation, we have taken into account data regarding the security-based swap market and especially data regarding the activity—including activity that may be suggestive of dealing behavior—of participants in the single-name credit default swap market. [472]

As discussed above, a de minimis exception eliminates key Title VII protections for some market participants by regulating less dealer activity. Conversely, an appropriately applied de minimis exception may provide an objective test when there is doubt as to whether particular activities may cause a person to be deemed to be a dealer; [473] allow non-dealers to accommodate the incidental security-based swap needs of existing clients; and help to facilitate competition by allowing the entry of new dealers into the market. In addition, as discussed above, a de minimis exception may promote regulatory efficiency by providing a framework to help focus dealer regulation upon those entities for which such regulation is warranted, rather than upon entities that engage in relatively limited amounts of dealing activity. [474]

i. Providing for Regulatory Coverage of the Vast Majority of Dealing Activity

In seeking to develop a de minimis exception that preserves key counterparty and market protections while promoting regulatory efficiency, we have considered the comparative amount of security-based swap dealing activity that could fall outside the ambit of dealer regulation as a result of the exception. In doing so we have considered not only the security-based swap market as it currently exists, but also how the market reasonably may be expected to change after the full implementation of Title VII.

In performing this comparative exercise we are, in part, drawing inferences from the CDS Data Analysis, a dataset released by the SEC staff that characterizes nearly all transactions in single-name credit default swaps during the 2011 calendar year. [475] Though the final rules apply to all security-based swaps, not just single-name credit default swaps, the SEC believes that these data are sufficiently representative of the market to help inform the analysis because an estimated 95 percent of all security-based swap transactions appear likely to be single-name credit default swaps. [476] The SEC also recognizes that although the de minimis exception is applicable to persons only with respect to their dealing activity, the CDS Data Analysis contains transactions reflecting both dealing activity and non-dealing activity, including transactions by persons who may engage in no dealing activity whatsoever. [477]

As described more fully in the CDS Data Analysis, to ascertain which entities might be transacting as dealers, and which may not be, various criteria were employed as indicia of possible dealing activity. In each case, the results suggest the great extent to which there is currently a high degree of concentration of potential dealing activity in the single-name credit default swap market. For example, using the criterion that dealers are likely to transact with many counterparties who themselves are not dealers, analysis of 2011 transaction data show that only 28 out of 1,084 market participants have three or more counterparties that themselves are not recognized as dealers by ISDA. [478] As the data show, 15 of these 28 potential dealers exceeded a threshold of $100 billion notional transacted in single-name credit swaps during 2011, which accounts for over 98 percent of the 28 entities' total activity. [479] At a lower threshold of $10 billion notional, 21 of the 28 potential dealers are included (representing 99.7 percent of the activity of potential dealers), and at an even lower threshold of $3 billion notional, 25 potential dealers are included (representing 99.9 percent). [480]

Other criteria for identifying possible dealing activity based on the number of an entity's non-dealer counterparties similarly suggest a high degree of concentration of dealing activity within the current security-based swap market. [481] Criteria that consider the number of an entity's total single-name security-based swap counterparties, [482] criteria that consider alternative factors for identifying dealing activity, [483] and certain combined criteria [484] further suggest a high concentration of dealing activity within the security-based swap market.

While less data are available in connection with other types of instruments constituting security-based swaps, such as equity swaps, the available data similarly suggest a high concentration of positions in those instruments among potential dealers. [485]

Though inspection of the data does not seem to suggest a single precise de minimis threshold, the above analysis of potential dealing activity is useful in that it reveals a range of possible thresholds from $100 billion to $3 billion that would cover anywhere from 98 percent through 99.9 percent of the total activity of all potential dealers in 2011. However, these thresholds—and their implied market coverage ratios—only reflect levels of activity that exist in today's highly concentrated market. In order to further narrow the range of possible thresholds, and to select an appropriate level for the de minimis exception, the analysis must consider the potential state of the market as it might reasonably exist after the implementation of Title VII.

ii. Avoiding Gaps Resulting From the Regulatory Changes in Conjunction With the Exception

Although the overall portion of security-based swap activity that would appear to be subject to dealer regulation based on current measures of dealing concentration in the market constitutes an important factor to consider in balancing the regulatory burdens and benefits associated with a de minimis exception, analysis of the current market should not serve as the sole mechanism for setting the exception.

In particular, sole reliance on an approach that focuses on current measures of market concentration would not adequately account for likely changes to the market associated with the implementation of regulation. In part, these changes may be a direct result of the full implementation of Title VII—including enhancements to transparency and increases in central clearing—as those changes reasonably may be expected to reduce the concentration of dealing activity within the market over time. [486] Also, to the extent implementation of Title VII permits new dealers to enter the market, the availability of a de minimis exception would mean those new dealing entrants would fall outside the ambit of dealer regulation, either for the long term or until their dealing activity surpasses the applicable notional threshold. [487] Accordingly, de minimis thresholds that are based solely on the current state of the market, including the current concentration of dealing activity within the market, may reasonably be expected to fail to account for the amount of dealing activity that in the future could fall outside of the ambit of dealer regulation due to the exception. [488]

For example, as discussed above, when possible dealers in single-name credit default swaps are identified by an entity having three or more counterparties that are not recognized by ISDA as being dealers, entities with notional transactions in excess of $100 billion over a 12 month period represent over 98 percent of the total activity of all such possible dealers over that period, leaving two percent of possible dealing activity below that level. [489] However, a de minimis threshold of $100 billion would allow new entrants to commence engaging in unregulated dealing in competition with persons who are regulated as dealers pursuant to Title VII, which, depending on the number and size of such entrants, could significantly decrease the portion of dealing activity in the market done by registered dealers (at least until the point that new entrants cross the de minimis threshold, if they do at all). For example, if 15 new entrants [490] were to engage in security-based swap dealing activity up to a $100 billion threshold, the result could be that nearly 15 percent of dealing activity within the single-name credit default swap market would be left outside of the ambit of dealer regulation. [491]

Similarly, a de minimis threshold of $25 billion may also lead to a material reduction in the portion of the market covered by registered dealers. For example, using the same assumptions as above, 15 new entrants up to a $25 billion threshold could leave over four percent of dealing activity in the market outside of the ambit of dealing regulation. [492] When other metrics are used to identify possible dealing activity, the possibility of a significant regulatory gap remains. [493]

Overall, it is reasonable to conclude that the higher the de minimis threshold, the greater the likelihood that the exception, combined with other changes resulting from the implementation of Title VII that may encourage new entrants, will lead to a proportionately larger amount of unregulated (except with respect to antifraud and anti-manipulation prohibitions) dealing activity. [494] We believe that it is reasonable to interpret the statutory language of the de minimis exception in a way that prevents a proportionately large amount of dealing activity within the security-based swap market from falling outside the ambit of dealer regulation. Accordingly, choosing to set a lower de minimis threshold from among the range of potential thresholds would limit the amount of potential future dealing activity that could be transacted without being subject to dealer rules and regulations. [495]

iii. Promoting Statutory Counterparty Protections

Sole reliance on an approach based on overall market coverage in balancing regulatory burdens and benefits would also threaten to unduly discount important counterparty protection interests, as discussed above and highlighted in the proposal. [496] For example, in light of data indicating that $5 million constitutes a common notional size for a single-name credit default swap position, [497] a de minimis notional threshold of $25 billion annually would permit an unregistered dealer to engage in as many as 5000 trades of that size. The counterparties to these unregistered dealers would not receive the benefit of the protections that Title VII affords to the counterparties of registered dealers. These include, among others, the segregation protections afforded to persons who post margin to dealers in connection with over-the-counter security-based swap transactions. [498] Accordingly, this consideration also suggests that choosing a de minimis threshold closer to the lower end of the range of potential thresholds would better preserve the counterparty protections contemplated by Title VII.

c. Balancing Reflected in the Final Rules—Credit Default Swaps That Constitute Security-Based Swaps

The final thresholds that implement the de minimis exception (and corresponding phase-in levels) address security-based swaps that are credit default swaps separately from other types of security-based swaps, in light of differences in the respective markets.

i. General Threshold for Credit Default Swaps That Constitute Security-Based Swaps

We conclude that $3 billion over the prior 12 months constitutes an appropriate notional threshold for applying the de minimis exception in connection with dealing activity involving credit default swaps that constitute security-based swaps.

In reaching this conclusion, we recognize the significance of comments that supported the proposed $100 million threshold, [499] and that urged caution in raising that proposed threshold, [500] as well as commenters who supported increases to the threshold. [501] We further recognize the importance of applying the de minimis exception in a way that promotes regulatory efficiency. We also recognize the range of potential thresholds suggested by the data currently available. Based on the competing factors described above, we believe that $3 billion reflects a reasonable notional threshold—though not necessarily the only such threshold.

In our view, the currently available data regarding the single-name credit default swap market indicates that a notional threshold of $3 billion would be expected to result in the regulation, as dealers, of persons responsible for the vast majority of dealing activity within that market, both as of today and, as described above, in the future as the benefits of the other Title VII rules are implemented and new dealer entrants come to market. [502]

In providing for a $3 billion notional threshold, we also recognize the threshold would permit an unregistered dealer annually to engage in up to 600 security-based swaps (as opposed to 20 transactions under the proposed threshold, assuming a $5 million average notional size). In this regard, we note that Congress, in another statutory de minimis exception within the Exchange Act, determined that 500 securities transactions annually constituted a de minimis amount of transactions for banks under the “broker” definition. [503] We further believe that a $3 billion threshold appropriately addresses commenter concerns regarding the de minimis exception being unduly narrow. [504]

In adopting this $3 billion threshold, we have carefully considered one commenter's view that the CDS Data Analysis suggests that the proposed $100 million threshold in fact is too high, and that any increase in that proposed $100 million threshold would be arbitrary and capricious. [505] In reaching these conclusions, the commenter focused on the number of entities that potentially are engaged in dealing activity but that could be excluded based on particular de minimis thresholds. For example, the commenter indicated that pursuant to one of the CDS Data Analysis's combined metrics for identifying dealing activity, a de minimis threshold of $3 billion could lead to the exclusion of up to 58 percent of all persons engaged in possible dealing activity. The commenter further suggested that some entities engaged in dealing activity may reduce their activities to take advantage of the de minimis exception and hence reduce liquidity, and argued that there would be no basis for the exception to be based on a market participant's percentage of total security-based swap activity. [506]

It is important to recognize that while the commenter focused on the number of entities that might be excluded pursuant to the exception, and suggested that higher notional dollar amount thresholds could lead to the exclusion of a larger number of entities, the statutory provision for the de minimis exception does not require the exemption of a “de minimis number” of dealers. The statute instead requires the exemption of persons engaged in a “de minimis quantity” of dealing activity. [507] The statutory language therefore indicates that the focus of the rule implementing the exception should be the amount of an entity's dealing activity, not how many entities ultimately may be able to take advantage of the exception.

Also, although the commenter implied that there would be no basis for the rule implementing the exception to take into account a market participant's security-based swap dealing activity compared to total dealing activity in the market, for the reasons discussed in this section we believe that such an approach can appropriately provide for the regulatory coverage of the vast majority of dealing activity in a way that promotes regulatory efficiency, without leading to unwarranted regulatory gaps. In contrast, in our view the commenter did not persuasively articulate a strong rationale for adopting the alternative approach proposed in the letter, which would appear to lead to the registration of a number of dealers that proportionately engage in a very small amount of dealing activity. [508]

In support of its approach, the commenter emphasized data regarding persons who meet certain combined criteria outlined in the CDS Data Analysis. As discussed above, we believe that criteria based on the number of an entity's counterparties that are not recognized as dealers deserve special weight due to the potential consistency of those criteria with the dealer-trader distinction. [509] Identifying dealer activity using those criteria does not support the view that a $3 billion threshold would lead to the exclusion of a large number of entities engaged in dealing activity. [510]

Finally, we also are not persuaded by the commenter's suggestion that a number of entities engaged in dealing activity would reduce those activities to take advantage of a $3 billion de minimis threshold, and hence reduce liquidity in the market by five percent. To reach that figure, the commenter needed to exclude the vast majority of dealing activity in the market. [511] While we recognize that it is possible that current market participants may adjust their dealing activity in light of the de minimis threshold, and that this potentially could reduce the liquidity provided by certain entities, we also recognize that the de minimis exception has the potential to promote liquidity by facilitating new entrants into the market.

ii. Phase-in Period in Connection With Dealing Activity Involving Credit Default Swaps That Constitute Security-Based Swaps

The final rules further provide that persons with notional dealing activity of $8 billion or less over the prior 12 months involving credit default swaps that constitute security-based swaps would be able to avail themselves of a phase-in period. [512] Those persons would not be subject to the generally applicable compliance date that occurs no later than 60 days following publication of these final rules in the Federal Register. [513]

The use of a phase-in period—in connection with a person's status as a security-based swap dealer and in connection with the other regulatory requirements that are appurtenant to dealer status—is intended to facilitate the orderly implementation of Title VII. In addition, the phase-in period will afford the SEC additional time to study the security-based swap market as it evolves in the new regulatory framework and will allow potential dealers that engage in smaller amounts of activity (relative to the current size of the market) additional time to adjust their business practices, while at the same time preserving the focus of the regulation on the largest and most significant dealers. The SEC also recognizes that the data informing its current view of the de minimis threshold is based on the market as it exists today, and that the market will evolve over the coming years in light of the new regulatory framework and other developments.

Accordingly, while the SEC believes that a $3 billion notional threshold reflects an appropriate long-term standard based on the currently available data, [514] it also is appropriate to provide for a phase-in period for those entities with $8 billion or less in dealing activity, because subsequent developments in the market or the evaluation of new data from the security-based swap reporting facilities contemplated by the Dodd-Frank Act may suggest that the threshold should be increased or decreased. In particular, the implementation of security-based swap data reporting under the Dodd-Frank Act will result in significant new data and afford an opportunity to review the Commission's determination to establish a $3 billion threshold.

For these reasons, an important part of the report that the SEC is directing its staff conduct with regard to the definitions of “security-based swap dealer” and “major security-based swap participant” (described in detail below) will be a consideration of the operation of the de minimis exception following the full implementation of Section 15F under Title VII. [515] The SEC will take into account this report, along with public comment on the report, in determining whether to propose any changes to the rule implementing the de minimis exception, including any increases or decreases to the $3 billion threshold. The report will be linked to the availability of data regarding the activity of regulated security-based swap market participants in that it must be completed no later than three years [516] following a “data collection initiation date” that is the later of: the last compliance date for the registration and regulatory requirements for security-based swap dealers and major security-based swap participants under Section 15F of the Exchange Act; or the first date on which compliance with the trade-by-trade reporting rules for credit-related and equity-related security-based swaps to a registered security-based swap data repository is required. [517]

In light of the available data—and the limitations of that data in predicting how the full implementation of Title VII will affect dealing activity in the security-based swap market—the SEC believes that $8 billion constitutes an appropriate level for the availability of the phase-in period. The available data indicate that such a level generally comports with the balance of interests that informed the determination of the appropriate long-term threshold of $3 billion described above. In particular, the $8 billion level should still lead to the regulation of persons responsible for the vast majority of dealing activity within the market. [518] In addition, we do not believe that providing a phase-in period for persons with notional dealing activity over the prior 12 months of less than $8 billion would lead to a risk of an undue portion of the market falling outside of the ambit of dealer regulation, even after considering the potential entry of unregulated new dealers into the market. [519]

The final rule provides that the phase-in period will continue until the “phase-in termination date” that the SEC will publish on its Web site and in the Federal Register. [520] In particular, the rule provides that nine months following publication of that report, and after giving due consideration of the report and associated public comment, the SEC may either: (1) Terminate the phase-in period and by order establish and publish the phase-in termination date; or (2) determine that it is necessary or appropriate in the public interest to propose an alternative de minimis threshold, in which case the SEC, by order published in the Federal Register, will provide notice of that determination and establish the phase-in termination date. [521] If the SEC does not establish the phase-in termination date in either of those ways, the phase-in termination date shall automatically occur in any event on what would be a date certain, which will be five years following the data collection initiation date. [522]

These provisions should allow sufficient time for the staff to complete its report, for the SEC to receive and review public comment on the report, and for the SEC to draw conclusions regarding establishing the phase-in termination date or proposing potential changes to the rule implementing the de minimis exception, in a way that also promotes the orderly and predictable termination of the phase-in period. [523]

This phase-in period will not be available in connection with the $25 million threshold for dealing activity involving special entities, discussed below. In addition, the final rule provides that this phase-in period will not be available in connection with security-based swap dealing activities involving natural persons, other than natural persons who qualify as ECPs by virtue of CEA section 1a(18)(A)(xi)(II), which addresses natural persons who have $5 million or more invested on a discretionary basis and who enter into a security-based swap to manage the risk associated with their assets and liabilities. [524] These limitations to the availability of the phase-in period are consistent with the Dodd-Frank Act's goal of helping special entities be in a position to benefit from the counterparty protections associated with the regulation of registered security-based swap dealers under Title VII, as well as the SEC's mandate to protect participants in the securities markets.

Persons who are able to avail themselves of the phase-in period, of course, will not be required to do so. Any person that chooses to register with the SEC as a security-based swap dealer shall be deemed to be a security-based swap dealer subject to all applicable regulatory requirements for such registrants, regardless of whether the person engages in security-based swap dealing activity in an amount that is below the applicable de minimis threshold or phase-in level. [525]

d. Balancing Reflected in the Final Rules—Other Types of Security-Based Swaps

The final rule provides that the de minimis exception for dealing activity involving security-based swaps other than credit default swaps will be based on a threshold of $150 million notional over the prior 12 months. [526] In addition, a phase-in period will be available in connection with persons whose dealing activity involving those instruments is $400 million or less in notional amount over the prior 12 months.

These amounts reflect roughly one-twentieth of the corresponding amounts associated with the exception for credit default swaps that constitute security-based swaps. As discussed above, while less data is available regarding other types of security-based swaps than is available regarding single-name credit default swaps, the available data is consistent in indicating that those other types of security-based swaps on a notional basis currently comprise roughly one-twentieth of the total amount of instruments that will be expected to constitute security-based swaps. [527] In light of this significantly smaller market, we believe that a $3 billion notional threshold would threaten to cause an overly large portion of dealing activity within the market to fall outside the ambit of dealer regulation.

In this regard, we note that it is likely that there are fewer barriers to entry in connection with acting as a dealer in security-based swaps such as equity swaps and total return swaps on debt than there are in connection with acting as a dealer in single-name credit default swaps. [528] We also note that because equity swaps and total return swaps on debt can serve as close economic proxies for equity and debt securities, an overly broad de minimis threshold in connection with such instruments could threaten to undermine the Exchange Act framework for regulating persons who act as dealers in equity and debt.

At the same time—notwithstanding the smaller scope of this market and the lesser availability of data regarding dealing activity within the market—we do not believe that it is necessary to make the de minimis exception unavailable in connection with dealing activity involving security-based swaps that are not credit default swaps. In this regard we particularly note that the limited available data regarding equity swaps suggests a high degree of concentration in dealing activity involving those instruments, [529] which indicates that an appropriately sized de minimis threshold can be expected to promote regulatory efficiency.

Balancing those factors, we conclude that a $150 million annual notional threshold is appropriate to implement the de minimis exception in connection with security-based swaps that are not credit default swaps, consistent with our understanding of the comparative size of that market as applied to the threshold applicable to credit default swap dealing activity. For reasons similar to those described above, we conclude that there should be a phase-in period available to persons whose annual notional dealing activity in connection with security-based swaps that are not credit default swaps is no more than $400 million in annual 12-month notional amount. This phase-in period is subject to the same limitations regarding transactions involving special entities and natural persons as apply to the phase-in period for credit default swaps. It also will be subject to the same provisions regarding the termination of the phase-in period as apply in connection with credit default swaps. [530] The comparative lack of data involving these markets—in contrast to the market for single-name credit default swaps—particularly highlights how the use of a phase-in period that is linked to the availability of post-implementation data is appropriate. [531]

As above, a person who is eligible to take advantage of the phase-in period in connection with these types of security-based swaps may nonetheless register as a security-based swap dealer.

e. Dealing Activity Involving Special Entities

Consistent with the proposal, the final rules in general will cap an entity's dealing activity involving security-based swaps at no more than $25 million notional amount over the prior 12 months when the counterparty to the security-based swap is a special entity. [532] There will be no phase-in period in connection with transactions involving special entities. In adopting this threshold, we recognize the serious concerns raised by commenters that stated that the de minimis exception should not permit any dealing activities involving special entities in light of losses that special entities have incurred in the financial markets, [533] as well as the special protection that Title VII affords special entities. [534]

At this time, the final rule does not fully exclude such dealing activity from the exception, in light of the potential benefits that may arise from a de minimis exception. In this way, the threshold would not completely foreclose the availability of security-based swaps to special entities from unregistered dealers—as $25 million would annually accommodate up to five single-name credit default swaps of a $5 million notional size—but the threshold would limit the financial and other risks associated with those positions for a special entity, which would in turn limit the possibility of inappropriately undermining the special protections that Title VII provides to special entities.

In reaching this conclusion we recognize that special entities do participate in the single-name credit default swap market, given that an analysis of market data indicates that in 2011 special entities were parties to over $40 billion in single-name credit default swap transactions. [535] At the same time, the impact of this $25 million threshold—particularly concerns that the threshold may foreclose the ability of special entities to access dealers in the market—appears to be mitigated by the fact that the counterparties to those special entities tend to engage in notional transactions in single-name credit default swap well in excess of the general de minimis standards. [536] In light of the underlying counterparty protection issues, we see no basis to distinguish between types of security-based swaps in setting this special entity threshold.

For similar reasons, in the future as we consider whether to amend the de minimis exception we expect to pay particular attention to whether the threshold for transactions involving special entities should further be lowered.

f. Future Revisions to the Rule

As noted above and described in detail below in part V, the SEC is directing its staff to report on whether changes are warranted to the rules and interpretations implementing the security-based swap dealer definition, including the rule implementing the de minimis exception. [537] The SEC will take the report and associated public comment into account in determining whether to propose any changes to the rule implementing the exception. [538] Consistent with that possibility, the final rule provides that the SEC may change the requirements of the de minimis exception by rule or regulation. [539] Through this mechanism, the SEC may revisit the rule implementing the exception and potentially change that rule, for example, if data regarding the security-based swap market following the implementation of Section 15F under Title VII suggests that different de minimis thresholds would be appropriate. [540] In determining whether to revisit the thresholds, the SEC intends to pay particular attention to whether the de minimis exception results in a dealer definition that encompasses too many entities whose activities are not significant enough to warrant full regulation under Title VII, or, alternatively, whether the de minimis exception leads an undue amount of dealing activity to fall outside of the ambit of the Title VII regulatory framework, or leads to inappropriate reductions in counterparty protections (including protections for special entities). The SEC also intends to pay particular attention to whether alternative approaches would more effectively promote the regulatory goals that may be associated with a de minimis exception.

6. Registration Period for Entities That Exceed the De Minimis Factors

The de minimis exception raises implementation issues akin to those associated with the major participant definition, in that both provisions use tests that have retrospective elements to determine whether an entity must register and be subject to future regulation. As a result, some commenters have suggested that entities that surpass the de minimis thresholds should be able to take advantage of a grace period to undertake the process of registering as swap dealers or security-based swap dealers. [541] Otherwise, absent such a “roll-in” period, entities whose dealing activities surpass the relevant de minimis factors would immediately be in violation of dealer registration requirements. In light of these concerns, and the interest of avoiding undue market disruptions, the Commissions believe that it is appropriate to provide entities that exceed applicable the de minimis factors a period of time to register as dealers.

Accordingly, the final rules have been revised from the proposal to provide for a timing standard that is similar to what we are using in connection with the major participant definition. [542] That is, if an entity that has relied on the de minimis exception no longer is able to rely on the exception because its dealing activity exceeds a relevant threshold, the entity would have two months, following the end of the month in which it no longer is able to take advantage of the exception, to submit a completed application to register as a swap dealer or security-based swap dealer. [543]

Also, akin to the major participant definitions, [544] a person registered as a swap dealer or security-based swap dealer may apply to withdraw that registration, while continuing to engage in a limited amount of dealing activity in reliance on the de minimis exception, if that person has been registered as a dealer for at least 12 months. [545] This should help ensure that persons do not rapidly move in and out of dealer status based on short-term fluctuations in their swap or security-based swap activities.

The final rules implementing the de minimis exception do not provide any reevaluation period for entities that engage in a level of dealing activity above the de minimis thresholds, in contrast to the major participant definitions. [546] We do not believe that there is an appropriate basis for such a provision, particularly given that dealer regulation addresses customer protection and market operation and transparency concerns apart from risk concerns.

E. Limited Purpose Designation as a Dealer

1. Proposed Approach

The definitions of the terms “swap dealer” and “security-based swap dealer” provide that the Commissions may designate a person as a dealer for one type, class or category of swap or security-based swap, or specified swap or security-based swap activities, without the person being considered a dealer for other types, classes, categories or activities. [547]

In the Proposing Release, we noted that these provisions represent permissive grants of authority that do not require the Commissions to provide limited designations. [548] We further stated that a person that is covered by the definitions of the terms “swap dealer” or “security-based swap dealer” would be considered a dealer for all types, classes or categories of the person's swaps or security-based swaps, or activities involving swaps or security-based swaps, in light of the difficulty of seeking to separate a person's dealing activities from their non-dealing activities involving swaps or security-based swaps, unless such person sought and received designation as a dealer for only specified categories of swaps or security-based swaps, or specified activities. [549] We explained that this would provide persons the opportunity to seek a limited designation based on applicable facts and circumstances, and that we anticipated that a dealer could seek a limited designation at the time of its initial registration or later. [550]

In the Proposing Release, the CFTC further noted that non-financial entities such as physical commodity firms potentially may conduct dealing activity through a division rather than through a separately incorporated subsidiary, and that such an entity's swap dealing activity would not be a core component of its overall business. The CFTC added that if this type of entity registered as a dealer, certain swap dealer requirements would apply to the dealing activities of the division, but not necessarily to the swap activities of other parts of the entity. [551]

2. Commenters' Views

A number of commenters addressed the limited designation of dealers in conjunction with the limited designation of major participants. Many of the issues those commenters raised thus are relevant to both sets of definitions.

a. Presumption of Full Designation

A number of commenters objected to the proposed presumption that an entity would be designated as a dealer (or major participant) for all categories of swaps or security-based swaps and all of the person's activities connected to swaps or security-based swaps. Several commenters argued that this approach would be contrary to Congressional intent, [552] conflict with the statutory language, [553] or conflict with underlying policy concerns. [554] One commenter suggested that the Commissions lack the statutory authority to apply swap dealer requirements to an entity's non-swap dealing activities. [555]

b. Potential Types of Limited Designations

A number of commenters addressed potential types of limited designations. One expressed support for limited swap dealer designations for particularized business units and for particular swap categories, [556] while another requested that limited swap dealer designations be available based on any reasonable commercial groupings. [557] Some commenters urged that limited dealer designations should be available for the branches or business units of foreign swap dealers and security-based swap dealers with U.S.-based customers or U.S. business lines. [558]

c. Applications for Limited Designations

A number of commenters addressed issues relating to the application process for limited designations. Some commenters supported the ability of a person to apply for limited designations at the time of initial registration, [559] while one commenter sought clarification on how and when a person could apply for limited swap dealer status. [560] Some commenters suggested that entities should be considered to have a provisional limited designation upon the filing of a completed application for limited dealer designation. [561]

Some commenters requested further clarification as to what factors or criteria would be considered relevant to limited designation determinations. [562] One commenter stated that non-financial companies should have a presumption of limited swap dealer designation under certain circumstances. [563] Another commenter took the view that commercial firms should be able to determine whether to register a legal entity or a division as a dealer. [564] One commenter suggested the analysis consider the complexity of an entity's dealing and non-dealing activities, and further suggested that limited designations should automatically be available if an entity's dealing activities do not exceed 50 percent of its total swap activities. [565] Commenters also raised issues related to how a person's status as a financial or a non-financial entity affects a person's eligibility for limited designations. [566]

d. Application of Regulatory Requirements to Limited Dealers

Commenters also addressed issues related to the application of regulatory requirements to limited dealers. One commenter recommended that dealer regulatory requirements generally should apply only to a division undertaking limited dealing activities; that commenter further stated that capital requirements should be calculated based only on the activities of that division, while recognizing that capital must be held by the entity as a whole. [567] Other commenters argued that capital and margin requirements should only be applied to an entity on a limited basis. [568]

e. Miscellaneous Issues

One commenter recommended that non-financial entities that are deemed to be limited dealers (or major participants) be permitted to be treated as end-users for the aspects of their businesses that are not subject to the limited designation. [569] The commenter further suggested that the swaps “push-out” rule requirements of section 716 of the Dodd-Frank Act be interpreted so that an insured depository institution that is a limited purpose dealer would only have to push out the dealing portion of its swap business, and be allowed to retain the other aspects of its swaps business. [570] One commenter requested clarification as to whether a person that is a limited purpose dealer in connection with one category of swap could be a major participant in connection with another category (in light of the statutory language excluding dealers from the major participant definitions). [571]

3. Final Rules and General Principles

Consistent with the proposal, the final rules retain the presumption that a person who meets one of the dealer definitions will be deemed to be a dealer with regard to all of its swaps or security-based swaps activities, unless the CFTC or SEC exercises its authority to limit the person's designation as a dealer to specified categories of swaps or security-based swaps, or specified activities. [572] As discussed in the Proposing Release, moreover, a person may apply for a limited designation when it submits a registration application, or at a later time. [573] The final rules also contain a technical change from the proposed rules to clarify that limited designations may be based on a particular type, class or category of swap or security-based-swap. [574]

a. Default Presumption of Full Designation

Consistent with the proposal, the final rules retain the standard that a person that satisfies the “swap dealer” or “security-based swap dealer” definition in general would be considered a dealer for all types, classes or categories of the person's swaps or security-based swaps, or all activities involving swaps or security-based swaps.

The Commissions are not persuaded by the suggestion that this presumption is inconsistent with the statute, legislative intent or underlying policy. Not only is the relevant statutory language written as a grant of authority rather than a specific mandate to designate certain entities as limited purpose dealers, but the presumption also reasonably reflects the difficulty of separating a dealer's dealing activities from its non-dealing activities, and the challenges of applying dealer regulatory requirements to only a portion of a dealer's swap or security-based swap activities. [575]

We similarly are not persuaded by the view that the Commissions lack the authority to apply dealer regulation to non-dealing activities of a registered swap dealer or security-based swap dealer. [576] Certain of the statutory requirements applicable to swap dealers and security-based swap dealers—such as capital requirements—simply do not distinguish between a person's dealing activities and their non-dealing activities. [577] In other words, absent a limited designation, the statutory requirements applicable to dealers address the regulation of all of a dealer's swap or security-based swap activities. [578]

b. Demonstration of Compliance With Dealer Requirements

The Commissions will consider limited purpose applications on an individual basis through analysis of the unique circumstances of each applicant, given that the types of entities that engage in swap or security-based swap dealing are diverse and their organization and activities are varied. [579]

Regardless of the type of limited designation being requested, the Commissions will not designate a person as a limited purpose dealer unless it can demonstrate that it can fully comply with the requirements applicable to dealers.

Certain of the statutory requirements applicable to dealers particularly focus on the entity's swap or security-based swap activities and positions. These include, among other aspects, requirements related to trading records, documentation and confirmations. [580] An applicant for a limited purpose designation would have to demonstrate how it would satisfy those transaction-specific requirements in the context of a limited designation.

Other statutory requirements applicable to dealers particularly focus on the entity itself. These include requirements related to registration, capital, risk management, supervision, and chief compliance officers. [581] Here too, an applicant for a limited purpose designation would have to demonstrate how it would satisfy those requirements in the context of limited designations.

A limited purpose designation might be appropriate, for example, where a commercial agricultural company is a dealer in swaps related to a thinly-traded commodity, such as a particular fertilizer, but is not a dealer in, and does not wish to be subject to the swap dealer requirements with respect to its swaps that relate to broadly-traded commodities like corn or wheat (or where, say, a commercial energy company is a dealer in swaps involving a commodity to be delivered at a particular location and does not wish to be subject to the swap dealer requirements for its swaps involving that commodity to be delivered at other locations, for which it is not a swap dealer). A limited designation might also be appropriate so that the swap dealer requirements do not apply to interest rate or currency swaps that the agricultural or energy company enters into in managing its financial risk.

A limited purpose designee could be a particular business unit within a company. Additionally, a limited designation might be considered to “split the desk” by applying the swap dealer requirements solely to the designee's limited activities involving swaps not entered into for the purpose of hedging a physical position as defined in CFTC Regulation § 1.3(ggg)(6)(iii). Any particular limited purpose application will be analyzed in light of the unique circumstances presented by the applicant.

A key challenge that any applicant to a limited dealer designation will face is the need to demonstrate full compliance with the requirements that apply to the type, class or category of swap or security-based swap, or the activities involving swaps or security-based swaps, that fall within the swap dealer designation.

III. Amendments to the Definition of Eligible Contract Participant Back to Top

A. Background

The Dodd-Frank Act makes it unlawful for a person that is not an eligible contract participant (“ECP”) to enter into a swap other than on, or subject to the rules of, a DCM. [582] In addition, section 763(e) of the Dodd-Frank Act makes it unlawful for a person to effect a transaction in a security-based swap with or for a person that is not an ECP unless the transaction is effected on a national securities exchange registered with the SEC. [583] Moreover, section 768(b) of the Dodd-Frank Act makes it unlawful for a person to offer to sell, offer to buy or purchase, or sell a security-based swap to a person that is not an ECP unless a registration statement under the Securities Act of 1933 (“Securities Act”) [584] is in effect with respect to that security-based swap. [585] These provisions mean that persons can engage in neither swaps nor security-based swaps transactions with persons that are not ECPs on SEFs, on security-based SEFs, or on a bilateral, off-exchange basis.

The Dodd-Frank Act also amended the ECP definition by: [586] (i) Providing that, for purposes of CEA sections 2(c)(2)(B)(vi) and 2(c)(2)(C)(vii), the term ECP does not include a commodity pool in which any participant is not itself an ECP; (ii) raising the monetary threshold that governmental entities may use to qualify as ECPs, in certain situations, from $25 million in investments owned and invested on a discretionary basis to $50 million in investments owned and invested on a discretionary basis; [587] and (iii) replacing the “total asset” standard for individuals to qualify as ECPs with an “amounts invested on a discretionary basis” standard. [588]

Commodity pools may, among other things, enter into transactions involving foreign currency. ECP status is important for commodity pools that enter into the following types of foreign currency transactions (such commodity pools, “Forex Pools”): (i) Off-exchange foreign currency futures; (ii) off-exchange options on foreign currency futures; (iii) off-exchange options on foreign currency; (iv) leveraged or margined foreign currency transactions; and (v) foreign currency transactions that are financed by the offeror, the counterparty or a person acting in concert with the offeror or counterparty on a similar basis. [589] In some cases, discussed below in detail, if a Forex Pool does not satisfy the ECP definition applicable to commodity pools engaging in the types of foreign currency transactions noted above [590] and it engages in these types of foreign currency transactions (such transactions, “retail forex transactions” and such commodity pools, “Retail Forex Pools”), the transactions will be subject to a regulatory regime that imposes certain requirements and restrictions on the counterparties to the Retail Forex Pool, and, if the Retail Forex Pool engages in retail forex transactions other than with certain counterparties, on the commodity pool operator (“CPO”) who operates the Retail Forex Pool. These requirements and restrictions do not apply if the Forex Pool satisfies the ECP definition applicable to commodity pools engaging in the types of foreign currency transactions noted above.

The Commissions are adopting further definitions of the term “eligible contract participant” in the following six respects: (i) Generally prohibiting a Forex Pool from qualifying as an ECP if such Forex Pool directly enters into retail forex transactions [591] and has one or more direct participants that are not ECPs; [592] (ii) clarifying that, in determining whether a direct participant in a Forex Pool is an ECP, the indirect participants in the Forex Pool will not be considered unless such Forex Pool, a commodity pool holding a direct or indirect (through one or more intermediate tiers of pools) interest in such Forex Pool, or any commodity pool in which such Forex Pool holds a direct or indirect interest has been structured to evade Subtitle A of Title VII of the Dodd-Frank Act; [593] (iii) prohibiting a commodity pool from qualifying as an ECP unless it has total assets exceeding $5 million and is operated by a person described in CEA section 1a(18)(A)(iv)(II); [594] (iv) explicitly including swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants in the definition of ECP; (v) permitting a non-ECP to qualify as an ECP, with respect to certain swaps, based on the collective net worth of its owners, subject to several conditions, including that the owners are ECPs; and (vi) permitting a Forex Pool to qualify as an ECP notwithstanding that it has one or more direct participants that are not ECPs if the Forex Pool (a) is not formed for the purpose of evading regulation under CEA sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b) has total assets exceeding $10 million and (c) is formed and operated by a registered CPO or by a CPO who is exempt from registration as such pursuant to § 4.13(a)(3). In addition, the Commissions are issuing interpretive guidance regarding the definition of ECP to correct an inaccurate statutory cross-reference with respect to the ability of government entities to qualify as ECPs under CEA section 1a(18)(A)(vii). [595] The Commissions also are issuing interpretive guidance with respect to the ECP status of Forex Pools whose participants are limited solely to non-U.S. persons and which are operated by CPOs located outside the United States, its territories or possessions.

The Commissions note that commenters raised interpretive and other issues related to the ECP definition that the Commissions may consider in the future. [596]

B. Commodity Pool Look-Through for Retail Forex Transactions

1. Statutory Provisions

Prior to the Dodd-Frank Act, clause (A)(iv) of the ECP definition provided that a commodity pool was an ECP if it had $5 million in total assets and was operated by a person regulated under the CEA, regardless of whether each participant in the commodity pool was itself an ECP. [597] Section 741(b)(10) of the Dodd-Frank Act added a proviso to clause (A)(iv) [598] stating that a Forex Pool will not qualify as an ECP, solely for purposes of CEA sections 2(c)(2)(B)(vi) or 2(c)(2)(C)(vii) (i.e., retail forex transactions) if any participant in the Forex Pool is itself not an ECP. [599]

Thus, for purposes of retail forex transactions, the Dodd-Frank Act imposed a requirement to “look through” a Forex Pool—meaning that ECP status would be limited to Forex Pools in which each participant is itself an ECP. This is important for two reasons. First, a Forex Pool that does not qualify as an ECP can enter into a retail forex transaction described in CEA section 2(c)(2)(B)(i)(I) only with one of the federally-regulated counterparties enumerated in CEA sections 2(c)(2)(B)(i)(II)(aa) (U.S. financial institutions), [600] (bb) (certain brokers, dealers and their associated persons), [601] (cc) (certain futures commission merchants (“FCMs”) and their affiliated persons), [602] (dd) (certain financial holding companies) [603] or (ff) (certain retail foreign exchange dealers (“RFEDs”)) [604] (each an “Enumerated Counterparty” and collectively “Enumerated Counterparties”); the counterparty restriction does not apply to retail forex transactions described in CEA section 2(c)(2)(C)(i)(I)(bb) [605] entered into by a Forex Pool that does not qualify as an ECP, though such transactions are subject to antifraud protections and related enforcement provisions if entered into with a counterparty other than an Enumerated Counterparty described in CEA section 2(c)(2)(B)(i)(II)(aa), (bb) or (dd). [606] Second, the operator of a Retail Forex Pool engaging in retail forex transactions with an Enumerated Counterparty that is an FCM, specified affiliated person of an FCM or RFED must register with the CFTC as a CPO, [607] unless the CPO also is an Enumerated Counterparty under 2(c)(2)(B)(i)(II)(aa), (bb) or (dd) [608] or an exemption from CPO registration applies. [609] Moreover, CEA section 2(c)(2)(E)(ii)(I), [610] which was added by section 742(c)(2) of the Dodd-Frank Act, prohibits an Enumerated Counterparty from entering into retail forex transactions described in CEA section 2(c)(2)(B)(i)(I) with a person that is not an ECP “except pursuant to a rule or regulation of [the appropriate Federal regulator of such Enumerated Counterparty allowing such transactions] under such terms and conditions as [such regulator] shall prescribe.” CEA section 2(c)(2)(E)(iii)(II) [611] requires that such rules or regulations treat similarly all agreements, contracts, and transactions in foreign currency that are functionally or economically similar to CEA section 2(c)(2)(B)(i)(I) agreements, contracts, and transactions.

Separately, subclause (A)(v)(III) of the ECP definition, both before and after enactment of the Dodd-Frank Act, provides that a corporation, partnership, proprietorship, [612] organization, trust or other business entity may qualify as an ECP if it has a net worth exceeding $1 million and “enters into an agreement, contract, or transaction in connection with the conduct of the entity's business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity's business.” [613]

2. Proposed Approach

The Commissions stated in the Proposing Release that “in some cases commodity pools unable to satisfy the conditions of clause (A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as ECPs instead for purposes of retail forex” and that permitting such reliance would frustrate the intent of Congress in imposing the look-through requirement on Forex Pools in clause (A)(iv) of the ECP definition. [614]

The Commissions proposed to further define the term “eligible contract participant” to preclude a Forex Pool from qualifying as an ECP for purposes of retail forex transactions in reliance on clause (A)(v) of the ECP definition if such Forex Pool has any participant that is not an ECP and, therefore, is not an ECP due to the look-through provision added to clause (A)(iv). Further, because commodity pools can be structured in various ways and can have one or more feeder funds and/or pools, the Commissions proposed to preclude a Forex Pool from being an ECP for purposes of retail forex transactions if there was any non-ECP participant at any level of the pool structure (e.g., the pool itself, a direct participant that invests in the pool, or any indirect participant that invests in that pool through other pools or vehicles).

3. Commenters' Views

One commenter supported the Commissions' efforts to close the potential loophole of Forex Pools that are unable to qualify as ECPs due to the new look-through provision in clause (A)(iv) of the ECP definition instead qualifying as ECPs under clause (A)(v) of the ECP definition. [615] This commenter indicated that it shares the Commissions' concern that Forex Pools that do not satisfy the amended ECP definition due to the look-through provision for commodity pools in clause (A)(iv) may alternatively rely upon clause (A)(v) of the ECP definition to qualify as an ECP for purposes of retail forex transactions. [616] This commenter further stated that Congressional intent in requiring a look-through for Forex Pools would be frustrated if fraudulent pool operators could avail themselves of this alternative. [617]

However, several commenters recognized the importance of the concern about a potential loophole [618] but stated that the Commissions should revise the proposal to mitigate the potential adverse consequences to market participants. One commenter, for example, commented on the expected effects of the proposed rule on funds of funds (“FOFs”). [619] According to this commenter, FOFs (i) normally face as counterparties foreign subsidiaries of U.S. banks and foreign banks, and (ii) would incur substantial counterparty, documentation and operational costs in moving their retail forex transactions onto DCMs or toward the Enumerated Counterparties.

In a similar vein, two commenters advised that a substantial number of hedge funds, as well as publicly offered commodity pools, would, under the Commissions' proposal, fail to qualify as ECPs for purposes of retail forex transactions, as most such funds have at least one direct or indirect non-ECP participant. [620] These commenters indicated that this would disrupt the trading strategies employed by many commodity trading advisors (“CTAs”) on behalf of commodity pools. [621] One of these commenters suggested an anti-evasion approach combining a lower level of pool assets with a requirement that the commodity pool not be formed for the purpose of evading the regulatory requirements applicable to retail forex transactions. [622]

Another commenter argued that Congress did not include the look-through provision in clause (A)(v) of the ECP definition because of its effect on bona fide hedgers. [623] This commenter also advised that the primary entities affected are hedge fund and private equity fund managers investing in securities who use retail forex transactions solely to hedge investment portfolio currency risks, and/or because they accept subscriptions in currencies other than U.S. dollars. [624]

Several commenters disagreed with the Commissions' statement in the proposal that extending the look-through provision in clause (A)(iv) of the ECP definition to clause (A)(v) would effectuate Congressional intent. Two commenters noted that there is no specific Dodd-Frank Act provision requiring such a change. [625] Two other commenters argued that clause (v) of the ECP definition provides an independent basis for qualification as an ECP, which should not be affected by the changes in clause (A)(iv) of the ECP definition. [626]

One commenter indicated that the extraterritorial application of the proposed rules regarding the ECP definition is unclear. [627] Among other things, this commenter indicated it is unnecessary to extend the scope of the look-through to protect possible retail investors outside of the U.S., especially where a CPO has not marketed a pool in the U.S. and does not otherwise have any U.S. investors. [628]

Commenters proposed several alternative approaches that they believed would address the Commissions' concerns. One commenter suggested that the Commissions create a new category of ECPs for Forex Pools comprised entirely of qualified eligible persons (“QEPs”) [629] and operated by persons subject to regulation under the CEA. [630] This commenter also suggested that the Commissions create a new category of ECPs for Forex Pools that satisfy a monetary threshold for total assets or for the minimum initial investment of a Forex Pool to be sufficiently large that, in general, only legitimate pools would exceed such thresholds. [631] Finally, this commenter suggested that the Commissions create a category of ECPs for non-U.S. persons. [632] A second commenter suggested that the Commissions create a category of ECPs for commodity pools that are operated by a CPO or advised by a CTA subject to regulation by a foreign regulator comparable to the CFTC. [633]

One commenter suggested (i) allowing commodity pools and their counterparties to rely, for the duration of an investment and each time commodity pool participants make an investment decision, on participant ECP representations provided in connection with an initial investment, provided that each participant covenants to update such representations if they become inaccurate, and (ii) providing specific relief for FOFs because they generally invest all or substantially all of their assets in underlying portfolio funds and use retail forex transactions to reduce foreign exchange exposure. [634]

4. Final Rule

After considering commenters' concerns, the Commissions are adopting final rules that have been revised from the proposal. In particular, consistent with the statutory text of the Dodd-Frank Act, CFTC Regulation § 1.3(m)(5)(i) further defines the term “eligible contract participant” to prohibit a Forex Pool that directly enters into a retail forex transaction (i.e., a transaction-level commodity pool) [635] from qualifying as an ECP under clause (A)(iv) or clause (A)(v) of the ECP definition, solely for purposes of entering into retail forex transactions, if the pool has one or more direct participants that are not ECPs. In response to commenters' concerns described above, CFTC Regulation § 1.3(m)(5)(ii) is revised to provide that, in determining whether a commodity pool that is a direct participant in a transaction-level Forex Pool is an ECP, the indirect participants in the transaction-level Forex Pool [636] will not be considered unless such Forex Pool, a commodity pool holding a direct or indirect (through one or more intermediate tiers of pools) interest in such Forex Pool, or any commodity pool in which such Forex Pool holds a direct or indirect interest has been structured to evade Subtitle A of Title VII of the Dodd-Frank Act by permitting persons that are not ECPs to participate in agreements, contracts, or transactions described in section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity Exchange Act. That is, absent evasion, the Commissions are changing the proposed “indefinite look-through” to an “evasion-based look-through” in the final rule. [637]

In adding the look-through provision to the commodity pool prong of the ECP definition, Congress made a decision to protect retail foreign exchange investors by requiring that the participants in a Forex Pool qualify as ECPs for the Forex Pool itself to qualify as an ECP. The Commissions believe that the intent of the look-through provision—protecting Forex Pool participants from fraudulent and abusive conduct—must be given effect to comply with this Congressional mandate. Nevertheless, the Commissions acknowledge commenters' concerns about potential unintended consequences of applying an indefinite look-through to every direct and indirect participant of a Forex Pool, as proposed. Accordingly, to avoid unintended consequences and related costs for Forex Pools whose operators and managers have not historically presented the risks that the look-through provision was intended to address, [638] the Commissions are replacing the proposed indefinite look-through of every participant in a Forex Pool with a limited, evasion-based look-through pursuant to which a transaction-level Forex Pool will qualify as an ECP, for purposes of retail forex transactions, if all of such Forex Pool's direct participants are ECPs, and will look through a commodity pool participant in such Forex Pool only if it, at any level, has been structured to evade the look-through provision in clause (A)(iv) of the ECP definition.

The Commissions believe the final rule strikes the right balance between implementing strong protections for non-ECP commodity pool participants and not imposing undue burdens or costs on CPOs, CTAs and commodity pool participants related to retail forex transactions. In addition, the Commissions believe that replacing the indefinite look-through with the limited, evasion-based look-through alleviates many of the commenters' concerns. Accordingly, the Commissions believe it is appropriate to limit the look-through provision to the level of a commodity pool structure that enters into retail forex transactions and to look through commodity pools to their ultimate participants only in those cases in which it is required to prevent evasion of the protections for those persons whom Congress intended to be subject to retail forex transactions restrictions.

At the same time, the Commissions do not believe that Forex Pools failing to qualify as ECPs due to the look-through provision in clause (A)(iv) of the ECP definition should, nonetheless, be permitted unfettered access to ECP status under clause (A)(v). [639] The look-through provision for Forex Pools provides heightened investor protection from forex fraud for Forex Pool participants that are not themselves ECPs. Thus, the Commissions believe that permitting Forex Pools with one or more non-ECP participants to achieve ECP status by relying on clause (A)(v) of the ECP definition, which applies to business entities generally, would serve to undermine the look-through provision that Congress specifically imposed on Forex Pools under clause (A)(iv). [640]

Moreover, developments subsequent to the issuance of the Proposing Release should ameliorate commenters' concerns that CEA section 2(c)(2)(E)(ii)(I) significantly limits the universe of possible retail forex transaction counterparties. [641] At the time the Commissions issued the Proposing Release and throughout the comment period, the CFTC was the only Federal regulatory agency that had issued final rules governing retail forex transactions by its regulated persons and entities. [642] Since then, though, both the OCC and the FDIC finalized (effective July 15, 2011) rules governing retail forex transactions by Enumerated Counterparties regulated by those agencies. [643] In addition, the SEC has issued interim temporary final rules (also effective July 15, 2011) governing retail forex transactions by registered broker-dealers. [644] Also, the Federal Reserve Board proposed rules to govern retail forex transactions by its regulated banks on August 3, 2011. [645] As a result of these regulatory actions, Forex Pools that are not ECPs due to the look-through provision and who are subject to a counterparty limitation [646] may enter into retail forex transactions with any Enumerated Counterparty but for those regulated by the Federal Reserve Board. [647]

The Commissions believe that the final rules reasonably address commenters' concerns. In this regard, the Commissions note that in applying the look-through provision, the Commissions will consider the indirect participants in a transaction-level Forex Pool if such Forex Pool, a commodity pool holding a direct or indirect (through one or more intermediate tiers of pools) interest in such Forex Pool, or any commodity pool in which such Forex Pool holds a direct or indirect interest has been structured to evade Subtitle A of Title VII of the Dodd-Frank Act by permitting persons that are not ECPs to participate in agreements, contracts, or transactions described in section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Commodity Exchange Act. One example of a scheme to evade would be if a commodity pool tier has been included in the structure of the Forex Pool primarily to provide non-ECP participants exposure to retail forex transactions rather than to achieve any other legitimate business purpose. [648] One example of a “legitimate business purpose” that would not trigger the look-through provision is a FOF operated primarily for the purpose of investing in underlying funds and using retail forex transactions solely to hedge the currency risk posed by an unfavorable change in the exchange rate between the currency in which underlying funds accept investments and the currency in which FOF investors pay for their investments in the FOF. [649] Similarly, the Commissions would not consider a commodity pool using retail forex transactions solely for bona fide hedging purposes [650] with respect to currency risk as being structured to avoid the look-through provision. [651] The “participate in agreements, contracts, or transactions described in section 2(c)(2)(B)(i) or section 2(c)(2)(C)(i) of the Act” language of CFTC Regulation § 1.3(m)(5)(ii) is aimed at exposure to retail forex transactions as an asset class, investment strategy, or an end in itself, not at exposure to retail forex transactions solely designed for bona fide hedging purposes with respect to foreign exchange exposure arising in the course of a commodity pool's business. [652]

In applying the limited look-through provision in the final rule, the Commissions would consider a Forex Pool's direct participants to include not only persons that initially hold interests in the level of the commodity pool structure that enters into retail forex transactions, but also persons that can acquire those interests or that subsequently hold those interests. As applied to exchange-traded products (“ETPs”) that are Forex Pools, any person that acquires an interest in the ETP Forex Pool in secondary market transactions would be a direct participant. ETPs typically issue shares only in the large aggregations or blocks (such as 50,000 ETP shares) called “Creation Units.” An authorized purchaser, usually an investment bank, broker dealer or large institutional investor, may purchase a Creation Unit. After purchasing a Creation Unit, the authorized purchaser may hold the Creation Unit, or sell some or all of the ETP shares in the Creation Unit to investors in secondary market transactions by splitting up the Creation Unit and selling the individual ETP shares on a national securities exchange or in off-exchange transactions. The ability to break up the Creation Unit into ETP shares permits other investors, such as non-ECPs, to purchase the individual ETP shares in secondary market transactions.

All participants in an ETP Forex Pool must be ECPs when they purchase or otherwise acquire an interest in the ETP Forex Pool. In addition, an ETP Forex Pool will not be able to verify whether the persons that acquire interests in the ETP Forex Pool in exchange transactions are ECPs. The ability of non-ECPs to acquire interests in an ETP Forex Pool and the inability of the ETP Forex Pool to verify ECP status with respect to exchange transactions create a presumption that ETP Forex Pools are not ECPs and, therefore, are Retail Forex Pools. This presumption would not apply in the case of a Forex Pool that is structured in a manner that does not involve exchange trading and in which the Forex Pool would be able to verify the ECP status of its participants.

One commenter suggested that the Commissions allow commodity pools and their counterparties to rely on participant ECP representations provided in connection with an initial investment. [653] The Commissions note that the obligation to determine that the parties to retail forex transactions are ECPs is imposed on the CPOs of Forex Pools and the counterparties looking to enter into retail forex transactions with Forex Pools. In making that determination, the Commissions expect CPOs and retail forex transaction counterparties to Forex Pools to be guided by the principles for verifying the ECP status of a swap dealer's or major swap participant's counterparty discussed in the CFTC's recently adopted external business conduct standards, including the safe harbor. [654] Thus, solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation § 1.3(m)(5), the Commissions will permit CPOs and retail forex transaction counterparties to rely on written representations from, as applicable, pool participants or potential pool participants that the person making the representation is an ECP (or is a non-U.S. person; as discussed below in this section III.B.4., solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation § 1.3(m)(5), the Commissions will consider Forex Pools whose participants are limited solely to non-U.S. persons (and which are operated by CPOs located outside of the U.S., its territories or possessions) to be ECPs), or from Forex Pools that the Forex Pool is an ECP, provided that the CPO or retail forex transaction counterparty has a reasonable basis to so rely, just as swap dealers and major swap participants are permitted to do pursuant to the safe harbor in new CFTC Regulation § 23.430(d), 17 CFR 23.430(d). Solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation § 1.3(m)(5), a CPO or retail forex transaction counterparty will have a reasonable basis to rely on such written representations if the person making the representation specifies therein the provision(s) of, as applicable, section 1a(18) of the CEA or CFTC Regulation § 4.7(a)(1)(iv) pursuant to which the person qualifies as an ECP or a non-U.S. person, respectively, unless it has information that would cause a reasonable person to question the accuracy of the representation. [655] Solely for purposes of CEA section 1a(18)(A)(iv) and CFTC Regulation § 1.3(m)(5), persons representing that they qualify as non-U.S. persons based on CFTC Regulation § 4.7(a)(1)(iv)(D) must represent that they are relying on such provision as modified as discussed below (i.e., without the 10% carve-out for U.S. persons).

Furthermore, the CFTC recognizes that, despite a counterparty's reasonable good faith efforts to ensure that Forex Pools do not in fact have any U.S. participants, a situation may arise where a Forex Pool does turn out to have U.S. participants. If a counterparty has reasonable policies and procedures in place to verify the ECP status of Forex Pool counterparties and, notwithstanding such reasonable good faith efforts and following such policies and procedures, enters into retail forex transactions with such a Forex Pool in good faith and it was subsequently determined that U.S. participants represented no more than a de minimis number of participants or amount of ownership of the Forex Pool, absent other material factors, the CFTC would not expect to bring an enforcement action against the counterparty for entering into a retail forex transaction in contravention of the requirements of the retail forex regime. For purposes of this analysis only, and without this being viewed as a de minimis threshold for purposes of this rule or otherwise, the CFTC would consider as de minimis, ownership of units of participation of a Forex Pool held by U.S. participants of less than 10% of the beneficial interest in the Forex Pool. The fact that, absent other material factors, the CFTC would not expect to bring an enforcement action against a forex transaction counterparty in such case does not relieve any obligation on the part of the CPO of the Forex Pool either to register as a CPO, claim the 4.13(a)(3) exemption therefrom or redeem the U.S. participants as described above.

One commenter suggested that the Commissions allow commodity pools and their counterparties to rely on participant ECP representations provided in connection with an initial investment. [656] The Commissions believe that if participants make ECP representations in connection with an initial investment in a Forex Pool, absent an additional investment (which would require a new ECP verification, other than in the case of automatically reinvested distributions), the subsequent loss of a participant's ECP status would not cause the Forex Pool to lose its own ECP status for purposes of retail forex transactions so long as the operating agreement of the Forex Pool or the subscription or other agreement pursuant to which the participant invested in the Forex Pool requires the participant to advise the CPO of the Forex Pool promptly of a loss of the participant's ECP status. In the event of the loss of ECP status of a participant, the CPO would be required to redeem the non-ECP from the Forex Pool at the first opportunity following notification to avoid the Forex Pool losing its ECP status for subsequent retail forex transactions.

The Commissions are mindful that several commenters indicated that CPOs do not customarily include a question or representation as to ECP status in subscription agreements for pool participants, and stated that requiring CPOs to qualify or redeem existing participants due to the new look-through provision would be expensive, burdensome and disruptive. [657] In this regard, the Commissions note that the look-through requirement for commodity pools was imposed by statute. As a result of the Commissions adopting the limited look-through in the final rule (as compared to the proposed indefinite look-through), however, the number of commodity pools subject to the look-through provision should be dramatically reduced, reducing the number of pools subject to regulation of their retail forex transactions, and the associated costs, accordingly. [658]

Also, in response to commenter concerns that the look-through provision would be applied to entities other than commodity pools (e.g., operating companies), [659] the Commissions revised the text of CFTC Regulation § 1.3(m)(5)(i) to reflect their intent to apply the look-through provision solely to commodity pools qualifying as ECPs, if at all, under clause (A)(iv) and clause (A)(v) of the ECP definition. [660] This is consistent with the statutory text, which is limited to looking through commodity pools under clause (A)(iv) of the ECP definition, and the intent behind the look-through provision, as it relates to clause (A)(v) thereof.

Commenters also stated that Retail Forex Pools will no longer be able to enter into retail forex transactions with foreign financial institutions. [661] As discussed in section III.B.1. above, however, this is not the case with respect to retail forex transactions described in CEA section 2(c)(2)(C)(i)(I)(bb). With respect to retail forex transactions described in CEA section 2(c)(2)(B)i)(I), this is a consequence of the express statutory text of the Dodd-Frank Act, which removed non-U.S. financial institutions from the list of Enumerated Counterparties eligible to enter into retail forex transactions with non-ECPs. [662]

Commenters further suggested generally that the Commissions create additional categories of ECPs to address the Commissions' concerns regarding the potential loophole of Retail Forex Pools that are unable to qualify as ECPs due to the new look-through provision in clause (A)(iv) of the ECP definition qualifying as an ECP under clause (A)(v) of the ECP definition. While one commenter proposed adopting a new rule clarifying that Forex Pools comprised entirely of QEPs and operated by persons subject to regulation under the CEA are ECPs, [663] Congress chose to look to ECP status of Forex Pool participants, not QEP status, as the basis for determining whether such Forex Pools are ECPs. Therefore, it is more appropriate to rely on Retail Forex Pool participants' ECP status than to rely on QEP status to establish ECP status.

One commenter stated a concern regarding what it characterized as the lack of clarity surrounding the extraterritoriality impact of the proposed ECP rules. [664] The Commissions recognize the potential consequences of the broad look-through language in CEA section 1a(18)(A)(iv) [665] and are providing guidance as to the application of the look-through to Forex Pools whose participants are limited solely to non-U.S. persons and which are operated by CPOs located outside the United States, its territories or possessions.

As discussed below, while foreign entities are not necessarily immune from U.S. jurisdiction for commercial activities undertaken with U.S. counterparties or in U.S. markets, canons of statutory construction “assume that legislators take account of the legitimate sovereign interests of other nations when they write American laws,” [666] particularly when limited U.S. interests are at stake. [667]

The Commissions do not believe that Congress intended for Forex Pools with no U.S. participants and operated by CPOs located outside the United States, its territories or possessions to be subject to a U.S. retail forex regime and, therefore, will consider Forex Pools whose participants are limited solely to non-U.S. persons and which are operated by CPOs located outside the United States, its territories or possessions to be ECPs for purposes of CFTC Regulation § 1.3(m)(5). For this purpose, a Forex Pool participant is a non-U.S. person if it satisfies the definition of “Non-United States person” in CFTC Regulation 4.7(a)(1)(iv); provided, however, that, if a participant is an entity organized principally for passive investment, such as a pool, investment company or other similar entity, such entity will be considered to be a Non-United States person under paragraph (D) of CFTC Regulation 4.7(a)(1)(iv) for purposes of CFTC Regulation § 1.3(m)(5) solely if all units of participation in such passive investment vehicle participant are held by Non-United States persons. [668] A broader interpretation or relief is not appropriate at this time. [669]

C. ECP Status for Commodity Pools Under Clause (A)(v) vs. Under Clause (A)(iv) of the ECP Definition

1. Proposed Approach

The Commissions stated in the Proposing Release that they believe “some commodity pools unable to satisfy the total asset or regulated status components of clause (A)(iv) of the ECP definition may rely on clause (A)(v) to qualify as ECPs instead.” [670] The Commissions further stated in the Proposing Release that “a commodity pool that cannot satisfy the monetary and regulatory status conditions prescribed in clause (A)(iv) should not qualify as an ECP in reliance on clause (A)(v) of the ECP definition.” [671] Based on those views, the Commissions proposed to further define the term “eligible contract participant” to prevent such a commodity pool from qualifying as an ECP pursuant to clause (A)(v) of the ECP definition. This proposal applied to all commodity pools, not just Forex Pools engaged in retail forex transactions.

2. Commenters' Views

Two commenters argued that, had Congress wished to prevent commodity pools from relying on the general ECP provision for business entities in clause (A)(v), it could have expressly excluded commodity pools from clause (A)(v). [672] Another commenter attempted to illustrate that clause (A)(v) of the ECP definition is an independent basis for qualifying as an ECP by distinguishing clause (A)(v) from clause (A)(iv). [673]

One commenter expressed the view that it is unclear whether “subject to regulation under this Act” in CEA section 1a(18)(A)(iv)(II) [674] means a registered CPO or something else (e.g., a person excluded from the definition of a CPO, a CPO exempt from registration conditioned in part upon making a filing to claim such relief). [675]

3. Final Rule

The Commissions are adopting CFTC Regulation § 1.3(m)(6) as proposed, which states that “[a] commodity pool that does not have total assets exceeding $5,000,000 or that is not operated by a person described in subclause (A)(iv)(II) of section 1a(18) of the Act is not an eligible contract participant pursuant to clause (A)(v) of such Section.” [676] As noted, the Commissions are concerned that clause (A)(v) of the ECP definition may undermine the protections that specifically apply to commodity pool participants pursuant to the limitations on ECP status for commodity pools set forth in clause (A)(iv) of the ECP definition. Allowing a commodity pool that cannot satisfy the monetary and regulatory status conditions prescribed for commodity pools in clause (A)(iv) to qualify as an ECP under clause (A)(v) would undermine these protections.

The Commissions acknowledge the comments stating that clause (A)(v) of the ECP definition is an independent basis for qualifying as an ECP and that Congress did not explicitly provide that a commodity pool that fails to qualify as an ECP under clause (A)(iv) cannot do so under clause (A)(v). However, when specifically legislating for commodity pools, Congress determined that total assets of $5 million and operation by a person subject to regulation under the CEA (or a foreign equivalent) are necessary to assure appropriate protection for non-ECP participants in a commodity pool. Furthermore, the commenters' view that Congress's use of the disjunctive term “or” between clauses (A)(x) and (A)(xi) of the ECP definition means that an entity can rely on clause (A)(v) of the ECP definition, notwithstanding that such entity cannot satisfy a prong more specific to it, would largely render superfluous each clause under subparagraph (A) of the ECP definition other than clause (v) and clause (xi) (for individuals). [677] As such, the Commissions believe that the final rule adopted in this release is consistent with Congressional intent.

The Commissions also are mindful that one commenter expressed a concern that the Commissions' reliance on clause (A)(iv) of the ECP definition might cause commodity pools to lose their ability to claim ECP status under clauses of the ECP definition, other than clause (v), and asked the Commissions to clarify the meaning of the phrase “formed and operated by a person subject to regulation under the [CEA]” in clause (A)(iv). [678] In response, the Commissions note that a commodity pool that does not qualify for ECP status under clause (A)(iv) of the ECP definition may still qualify as an ECP under either of the two clauses of the ECP definition other than clause (A)(v) applicable to subcategories of commodity pools. Thus, registered investment companies and foreign equivalents may qualify as ECPs under clause (A)(iii) of the ECP definition, and ERISA plans and the other entities described in clause (A)(vi) of the ECP definition may qualify as ECPs thereunder. The Commissions' actions in this release do not change that result.

Also, with regard to that commenter's request for clarification, for purposes of CFTC Regulation § 1.3(m)(6), the Commissions interpret the language “subject to regulation under the [CEA]” in clause (A)(iv) of the ECP definition as requiring lawful operation of the commodity pool by a person excluded from the CPO definition, a registered CPO, or a person properly exempt from CPO registration. [679] Congress did not limit ECP status under clause (A)(iv) to commodity pools operated by persons registered as CPOs; it used the more encompassing phrase “subject to regulation” under the CEA. [680] On the other hand, to construe that phrase to include any person operating a commodity pool would render the phrase superfluous. [681] The commenters' view would enable a CPO that fails to register as required to claim that the commodity pool it operates is an ECP under clause (A)(v) and thus is not subject to regulation of its retail forex transactions. The Commissions believe that construing the phrase “formed and operated by a person subject to regulation under the [CEA]” to refer to a person excluded from the CPO definition, registered as a CPO or properly exempt from CPO registration appropriately reflects Congressional intent.

D. Dealers and Major Participants as ECPs

1. Proposed Approach

The Commissions proposed to add swap dealers, security-based swap dealers, major swap participants and major security-based swap participants to the ECP definition on the basis that such persons “are likely to be among the most active and largest users of swaps and security-based swaps.” [682]

2. Commenters' Views

Several commenters supported the proposed addition of swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants to the ECP definition. [683] No commenter opposed this aspect of the proposal.

3. Final Rule

The Commissions are adopting the new ECP categories as proposed. The rules as adopted clarify that the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant” have their respective meanings as defined in the CEA and the Exchange Act and as otherwise further defined by the Commissions. [684]

E. Government Entities: Incorrect Cross-Reference

1. Description of the Issue

Clause (A)(vii) of the ECP definition conditions the ECP status of governmental entities, and their political subdivisions, agencies, instrumentalities and departments (collectively, “government entities”), in part, on the identity of their counterparties. Specifically, a government entity may qualify as an ECP under the provision in clause (A)(vii) that requires the entity's counterparty to be “listed in any of subclauses (I) through (VI) of section 2(c)(2)(B)(ii)” of the CEA. [685] However, subclauses (I) through (III) of CEA section 2(c)(2)(B)(ii) [686] are unrelated to counterparty types (rather, they describe the dollar amounts that apply for purposes of retail forex transactions under CEA section 2(c)(2)(B)), and subclauses (IV) through (VI) of CEA section 2(c)(2)(B)(ii) no longer exist in the statute. Read literally, then, this provision of the ECP definition is inherently a nullity and, thus, cannot enable government entities to qualify as ECPs. [687]

2. Commenters' Views

One commenter traced the history of the relevant provisions and concluded that the reference to subclauses (I) through (VII) of CEA section 2(c)(2)(B)(ii) in clause (A)(vii) of the ECP definition is erroneous. [688] This commenter pointed instead to CEA section 2(c)(2)(B)(i)(II) [689] as the reference that should be included in clause (A)(vii) of the ECP definition because it lists the entities that are eligible to serve as counterparties in retail forex transactions.

This commenter noted that the cross-reference in clause (A)(vii) of the ECP definition was correct when it was added to the CEA as part of the CFMA, but that it became incorrect in 2008 when an unrelated amendment to the CEA was enacted [690] that changed the numbering of the CEA's provisions governing retail forex transactions but that failed to make a conforming amendment to clause (A)(vii) of the ECP definition. As a result of this 2008 amendment to the CEA, the list of entities that formerly appeared in subclauses (I) through (VI) of CEA sections 2(c)(2)(B)(ii) now appear in items (aa) through (ff) of CEA section 2(c)(2)(B)(i)(II) instead. [691] This commenter requested that “the Commissions correct this clearly erroneous reference in the definition of ECP through interpretive guidance, rulemaking or Commission order.” [692]

3. Interpretive Guidance

Clause (A)(vii) of the ECP definition contains an erroneous cross-reference to subclauses (I) through (VI) of CEA section 2(c)(2)(B)(ii). Accordingly, the Commissions are issuing interpretive guidance by identifying the counterparties with which a governmental entity can enter into swaps to attain ECP status under the provision in clause (A)(vii) that requires the entity's counterparty to be “listed in any of subclauses (I) through (VI) of section 2(c)(2)(B)(ii)” of the CEA. The Commissions consider a government entity covered by the counterparty limitation in clause (A)(vii) to be an ECP with respect to an agreement, contract, or transaction that is offered by, and entered into with, a person that is listed in items (aa) through (ff) of section 2(c)(2)(B)(i)(II) of the CEA. The limitation of ECP status “with respect to” a particular transaction is consistent with Congress' determination that, for purposes of this provision of clause (A)(vii), governmental entities may derive their ECP status from the status of their counterparty.

F. Qualification as an ECP With Respect to Swaps Used To Hedge or Mitigate Commercial Risk in Connection With the Conduct of an Entity's Business

1. Proposing Release

In the Proposing Release, the Commissions requested comment on whether any additional categories should be added to the definition of ECP, “such as the following categories suggested by commenters [on the ANPRM]: Commercial real estate developers; energy or agricultural cooperatives or their members; or firms using swaps as hedges pursuant to the terms of the CFTC's Swap Policy Statement.” [693] As noted above, the ECP definition is important because the Dodd-Frank Act amended the CEA to prohibit a person that is not an ECP from entering into swaps other than on or subject to the rules of a DCM. [694]

2. Commenters' Views

Several commenters supported the addition of categories to the definition of ECP because, these commenters said, not all current swap market participants are ECPs. Many of these commenters said that non-ECPs have entered into swaps in reliance on the Swap Policy Statement. [695] Commenters highlighted, among other things, the importance of the Swap Policy Statement to pass-through entities used by farmers, [696] operating companies [697] and commercial property developers, [698] noting that such entities may not meet the ECP criteria. According to these commenters, these pass-through entities often are small and medium-sized businesses that enter into interest rate swaps with lending financial institutions in reliance on the Swap Policy Statement. [699] The commenters explained that the loans usually are guaranteed by the principals of the entity entering into the swap, and that the borrower would qualify as an ECP if structured as a single-level corporate entity or sole proprietorship. [700] Commenters said that if these non-ECP entities were limited to swaps that are available on or subject to the rules of a DCM, many regional bank borrowers would lose the ability to use swaps, real estate companies would have less flexibility in risk management, and smaller lenders would be at a competitive disadvantage. [701] Another commenter said that Dodd-Frank Act provisions such as the end-user clearing exception indicate that Congress intended to preserve the availability of swaps used for business reasons rather than for investment or speculation. [702]

To mitigate the impact of restricting non-ECPs to swaps that are available on or subject to the rules of DCMs, some commenters said that an entity should be able to qualify as an ECP based on the financial qualifications of related entities, so long as various conditions proposed by the commenters are satisfied. Some commenters said that an entity should be eligible to be an ECP if its swap obligations are guaranteed by an ECP, [703] or if its controlling entity qualifies as an ECP under clause (A)(v) of the statutory definition. [704] Another commenter suggested revisions to the ECP definition that included looking to the ECP status or sophistication of the majority owner of an entity in determining if the entity itself is an ECP. [705] Other commenters suggested other provisions to allow non-ECPs to enter into swaps other than on or subject to the rules of a DCM, so long as the non-ECP meets various conditions indicating that the swap is used in connection with its line of business. [706]

Other commenters argued for per se ECP qualification based on their status as certain types of persons, such as farmers [707] or for ECP status based solely on a combination of a person's status and the swap being related to a person's line of business with no additional conditions. [708]

3. Final Rules and Interpretation

In response to the commenters' concerns, the CFTC is adopting CFTC Regulation § 1.3(m)(7) to permit an entity, in determining its net worth for purposes of subclause (A)(v)(III) of the ECP definition, [709] to include the net worth of its owners, solely for purposes of determining its ECP status for swaps used to hedge or mitigate commercial risk, provided that all of its owners are themselves ECPs (disregarding shell companies). Under CFTC Regulation § 1.3(m)(7) as adopted, an entity seeking to qualify under subclause (A)(v)(III) of the ECP definition in order to enter into a swap used to hedge or mitigate commercial risk is permitted to count the net worth of its owners in determining its own net worth, so long as all its owners are ECPs. This regulation applies only to entities that are otherwise eligible to rely on subclause (A)(v)(III) to determine ECP status; it does not expand or change the scope of application of that paragraph. [710]

CFTC Regulation § 1.3(m)(7) as adopted applies only when determining ECP status for swaps used to hedge or mitigate commercial risk. This new regulation does not apply when determining ECP status for other swaps or for security-based swaps, security-based swap agreements, mixed swaps, or agreements, contracts or transactions that are not swaps (regardless of the purpose for which they are used).

The Commissions have considered the comments indicating that, as currently structured, many businesses are owned by multiple legal entities and/or individuals, and the net worth of all the owners in the aggregate in some cases would satisfy the $1 million net worth requirement in subclause (A)(v)(III), even though the particular legal entity that enters into a swap does not have a net worth exceeding $1 million. [711] While the Commissions recognize that the requirement, in subclause (A)(v)(III)(aa) of the ECP definition, that the entity relying on that paragraph have a net worth exceeding $1 million evidences Congress' intent that only entities with this level of financial resources should be eligible for ECP status under this paragraph of the definition, the Commissions agree with commenters that application of this requirement in these circumstances would inappropriately limit the ability of business entities to use swaps to hedge or mitigate commercial risk. As a result, the Commissions are persuaded that in this limited situation, the entity should qualify as an ECP and be eligible to enter into swaps other than on or subject to the rules of a DCM, so long as the entity is using the swap to hedge or mitigate commercial risk and all of the owners of the entity are ECPs (other than shell companies).

In response to those commenters requesting per se ECP status or the ability to qualify as an ECP based on a combination of status and engaging in swaps related to a line of business, without further restriction, the Commissions do not believe it is necessary or appropriate to further define the term ECP to such an extent in order to address most commenters' concerns. The Commissions note that such approaches would undermine the prohibition in CEA section 2(e) [712] on non-ECPs executing swaps other than on or subject to the rules of a DCM. The Commissions also note that focusing solely on a link between a swap and a line of business would undermine the application of the ECP definition to swaps in that the various prongs of the ECP generally are linked to dollar thresholds, regulated status, or a combination of the two.

The Commissions also note that it currently is considering a draft petition for relief pursuant to CEA section 4(c)(6)(C) [713] for certain entities described in Federal Power Act section 201(f), [714] which may address the concerns of some commenters. Additionally, the Commissions are developing joint rules to further define the term “swap,” including the forward exclusion from the swap definition which, in turn, may result in certain transactions not being considered swaps. Further, the CFTC also is considering today a form of trade option exemption, which may further address commenters' concerns.

With respect to farmers, in response to the CFTC's Commodity Options and Agricultural Swaps rulemaking proposal, [715] commenters generally were of the view that the ECP definition is appropriate in its current form. [716] While the Commissions may consider providing further relief should experience show, after the ECP definition becomes effective, that further relief is warranted, neither the ECP definition nor the various actions cited in the foregoing paragraph are final, so providing further relief is premature. The Commissions' measured approach, which builds on the existing net worth requirement in the general entity ECP category, provides broad relief to many of the commenters (e.g., borrowers generally) while otherwise adhering to the existing ECP categories.

The Commissions note that commenters said that, because of the way some businesses are structured for tax, estate planning or other purposes, they enter into swaps through a legal entity that does not, by itself, qualify as an ECP even though the net worth of the business and its owners, taken in the aggregate, would qualify as an ECP pursuant to subclause (A)(v)(III) of the ECP definition. The Commissions believe that the best way to address this concern is to allow such a business to consider the net worth of all its owners in determining whether the net worth requirement in subclause (A)(v)(III) is satisfied. [717]

CFTC Regulation § 1.3(m)(7) is available only to an entity that seeks to qualify as an ECP under subclause (A)(v)(III) of the statutory definition in order to enter into a swap that will be used to hedge or mitigate commercial risk. The Commissions limited CFTC Regulation § 1.3(m)(7) to subclause (A)(v)(III) because this provision of the ECP definition is available to a business entity that uses swaps in connection with the conduct of its business or to manage risks associated with assets or liabilities related to the conduct of its business. [718]

The purpose of CFTC Regulation § 1.3(m)(7) is to maintain the ability of business entities to enter into swaps other than on or subject to the rules of a DCM for limited purposes. This regulation therefore is available only with respect to a swap that is used to hedge or mitigate commercial risk within the meaning of CFTC Regulation § 1.3(kkk). [719] CFTC Regulation § 1.3(m)(7) applies only if all of an entity's owners qualify as ECPs under the provision of the ECP definition applicable to such owner. Although some commenters suggested that an entity should be able to qualify as an ECP based on the status of its majority or controlling owners, [720] the Commissions believe that CFTC Regulation § 1.3(m)(7) should be available only when all of an entity's owners qualify as ECPs. The Commissions do not believe it would be appropriate to impair the protection of non-ECPs that flows from the requirement that non-ECPs enter into swaps only on or subject to the rules of a DCM. [721] In order to maintain these protections and prevent evasion, CFTC Regulation § 1.3(m)(7) provides that any shell company will be disregarded, and in order to determine if the underlying entity may use CFTC Regulation § 1.3(m)(7), each owner of such shell company must be an ECP. [722]

Correspondingly, in aggregating net worth for purposes of determining the ECP status of an entity pursuant to CFTC Regulation § 1.3(m)(7), if the entity is owned by a shell company, then it is the net worth of the owners of that shell company that is relevant, not the net worth of the shell company. [723]

Last, also in order to prevent evasion, CFTC Regulation § 1.3(m)(7)(ii)(C) specifies that an individual may rely on the proprietorship provision of clause (A)(v) of the statutory definition for purposes of determining its status as an ECP owner of an entity only if the proprietorship [724] status arises independent of the business conducted by such entity [725] and the individual proprietor acquires his/her interest in such entity (i) in connection with the conduct of the individual's proprietorship or (ii) to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the proprietorship. [726] The Commissions are adopting CFTC Regulation § 1.3(m)(7)(ii)(C) because they believe that the only circumstance in which a proprietorship should be considered an ECP for purposes of CFTC Regulation § 1.3(m)(7)(i) is if it is making an investment related to the proprietorship. [727] The ECP status of an individual acting other than with respect to its proprietorship is determined based on the ECP clause applicable to individuals. The Commissions note that they have authority to take action to prevent evasion of the provisions regarding shell companies and proprietorships by entities relying on CFTC Regulation § 1.3(m)(7) to establish ECP status.

G. ECP Status for Forex Pools Operated by Registered CPOs or CPOs Exempt From Registration Under Certain Conditions

1. Description of the Issue and Commenters' Views

Notwithstanding the modifications to the look-through provisions for Forex Pools discussed above in section III.B., the Commissions acknowledge commenters' concerns about the potential for unintended consequences arising from the look-through provisions of the Dodd-Frank Act. Several commenters asserted that many Forex Pools are operated by sophisticated, professional managers that do not need the protections of a retail forex regime designed to protect non-ECPs that are engaging in retail forex transactions. [728] More specifically, some commenters, based on CFTC enforcement actions involving Forex Pools, suggested that commodity pools of a sufficient size, and/or operated by a registered or exempt CPO, do not pose the risks of fraud and abuse of non-ECP customers that the statutory look-through provision is intended to address. [729]

As a result, commenters suggested that the look-through provision should not apply in determining ECP status of commodity pools that meet certain conditions. For example, commenters suggested that the look-through not be applied to a commodity pool with $10 million in total assets paired with another or other factors, such as not being structured to evade, [730] being subject to regulation under the CEA [731] or the CPO being registered as such. [732] Another commenter suggested requiring the total assets or minimum initial investment of a Forex Pool to be sufficiently large that, in general, only legitimate pools would exceed such thresholds. [733] This commenter suggested a total asset threshold of $50 million. [734]

Separately, one commenter also claimed that the statutory look-through, if strictly implemented, might inappropriately preclude Forex Pools and their CPOs, many of whom are registered, from engaging in retail forex transactions with swap dealers because swap dealers are not Enumerated Counterparties (and some swap dealers also may not be Enumerated Counterparties in a different capacity, such as being a U.S. financial institution). [735] This commenter stated that such a result could reduce close out netting opportunities in the event of the insolvency of a counterparty.

2. Final Rule

In response to commenters, the CFTC is adopting CFTC Regulation § 1.3(m)(8), pursuant to which certain Forex Pools may qualify as ECPs notwithstanding the look-through requirement. As adopted, CFTC Regulation § 1.3(m)(8) enables a Forex Pool that enters into a retail forex transaction to qualify as an ECP with respect thereto, irrespective of whether each participant in the Forex Pool is an ECP, if the Forex Pool satisfies the following conditions:

  • It is not formed for the purpose of evading CFTC regulation under Section 2(c)(2)(B) or Section 2(c)(2)(C) of the CEA or related CFTC rules, regulations or orders governing Retail Forex Pools and retail forex transactions);
  • It has total assets exceeding $10 million; and
  • It is formed and operated by a registered CPO or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3).

CFTC Regulation § 1.3(m)(8) as adopted requires that the Forex Pool not be formed for the purpose of evading CFTC regulation of Retail Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B) or (C). A Forex Pool that is formed for that purpose would not be an ECP under new CFTC Regulation § 1.3(m)(8).

CFTC Regulation § 1.3(m)(8) as adopted also requires that the Forex Pool have total assets exceeding $10 million to qualify as an ECP. The $10 million threshold is twice the current total asset threshold for a commodity pool to qualify as an ECP under CEA section 1a(18)(A)(iv). The Commissions believe the $10,000,000 threshold is appropriate in light of the potential regulatory burdens a higher threshold might impose on smaller commodity pools. The Commissions believe that such a threshold, coupled with the other conditions of the rule, is sufficiently high to assure that the protections provided to retail forex transactions are not needed for these types of commodity pools. The Commissions will vigilantly monitor developments with respect to Forex Pools, including enforcement activity, and revisit this total asset threshold if warranted by subsequent events.

Finally, CFTC Regulation § 1.3(m)(8) as adopted requires that Forex Pool be formed [736] and operated by a CPO registered as such with the CFTC or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3). The Commissions believe that the registered CPO aspect of this condition is appropriate for several reasons, including that it will ensure that the NFA oversees compliance by those registered CPOs relying on this new regulation. [737] CPO registration also provides a clear means of addressing wrongful conduct. [738] Although some commenters suggested that a CPO need only be “subject to regulation under the CEA” in order for a Forex Pool operated by that CPO to qualify as an ECP notwithstanding the look-through requirements, CFTC Regulation § 1.3(m)(8) instead requires that the CPO of a Forex Pool be registered as a CPO or be a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3), alternative conditions supported by other commenters. The Commissions are requiring operation by a registered CPO, or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3), as a condition for a Forex Pool to qualify for ECP status under CFTC Regulation § 1.3(m)(8) because, based on the data presented by commenters, CFTC enforcement actions involving Forex Pools rarely involve registered CPOs or CPOs exempt from registration as such. [739]

While NFA oversight of CPOs operating Retail Forex Pools is a useful criterion to determine whether an exclusion from the look-through provisions of CEA section 1a(8)(A)(iv) and CFTC Regulation § 1.3(m)(5) is warranted, the Commissions believe that Retail Forex Pools operated by CPOs exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3) also merit relief from those look-through provisions. On September 10, 2010, the CFTC published in the Federal Register a final rule revising the CPO registration exemption in CFTC Regulation § 4.13(a)(3) to incorporate retail forex transactions into the transactions subject to the alternative caps on the use of commodity interests [740] by CPOs claiming the exemption. [741] The CFTC explained in the related Federal Register proposing release that the proposed change to CFTC Regulation § 4.13(a)(3) was part of a proposal to adopt a comprehensive regulatory scheme to implement the CRA with respect to retail forex transactions (“CRA-Related Forex Proposal”). [742] The CFTC also explained that “the NFA-specified minimum security deposit for off-exchange retail forex transactions would be included among the amounts that cannot exceed 5 percent of the liquidation value of the pool's portfolio in order for the operator to claim the exemption from registration under Regulation 4.13(a)(3)” [743] and that “such amounts are roughly equivalent to initial margin and option premiums).” [744] The CFTC also described the CRA-Related Forex Proposal as “amend[ing] existing regulations as needed to clarify their application to, and inclusion in, the new regulatory scheme for retail forex.” [745] More recently, notwithstanding the Dodd-Frank Act's addition of the look-through provision in CEA section 1a(8)(A)(iv), the CFTC determined to retain the exemption from CPO registration under Regulation 4.13(a)(3), reasoning that “overseeing entities with less than five percent exposure to commodity interests is not the best use of the Commission's resources.” [746]

Given that, shortly before the adoption of the Dodd-Frank Act, the CFTC proposed to add retail forex transactions to those that can be entered into by CPOs claiming relief from registration as such under CFTC Regulation § 4.13(a)(3), that it finalized that action shortly after the Dodd-Frank Act was adopted and that it recently left CFTC Regulation § 4.13(a)(3) in place despite having proposed to withdraw that CPO registration exemption, and for the reasons described above, the Commissions believe CPOs exempt from registration as such pursuant to CFTC Regulation 4.13(a)(3) and operating Retail Forex Pools should be able to continue to do so outside the retail forex regime.

Section 712(d)(2)(A) of the Dodd-Frank Act grants the Commissions the authority to adopt such rules related to the ECP definition as the Commissions determine are necessary and appropriate, in the public interest, and for the protection of investors. Based on commenters' views, the Commissions have determined that CFTC Regulation § 1.3(m)(8) as adopted is necessary and appropriate because the statutory look-through provision, if strictly implemented, would subject Forex Pools operated by CPOs that are sophisticated, professional asset managers to an array of additional compliance costs and deprive them of access to swap dealers as counterparties when engaging in retail forex transactions. [747] The Commissions also have determined that it is appropriate to limit the availability of ECP status under CFTC Regulation § 1.3(m)(8) to Forex Pools operated by registered CPOs or by CPOs exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3). [748] The conditions in CFTC Regulation § 1.3(m)(8) also are appropriate in that they require Forex Pools seeking ECP status thereunder to have total assets exceeding $10 million. Historically, CFTC enforcement actions have involved fewer instances of misconduct by CPOs of Forex Pools with total assets above this threshold. [749]

The Commissions have determined that CFTC Regulation § 1.3(m)(8) is in the public interest in that it will make available a category of counterparty (i.e., swap dealers) that likely would not otherwise be available, and help to assure that sophisticated, professional managers operating qualifying Forex Pools can continue to engage in retail forex transactions. The Commissions have determined that the conditions of CFTC Regulation § 1.3(m)(8) are sufficient for the protection of investors for the reasons discussed above, such as a significant reduction in the incidence of Forex Pool misconduct among CPOs, whether registered as such or exempt therefrom, operating Forex Pools with more than $10 million in total assets. The Commissions intend to monitor developments in the Forex Pool area and will revisit the conditions of this regulation as warranted by subsequent events.

IV. Definitions of “Major Swap Participant” and “Major Security-Based Swap Participant” Back to Top

The statutory definitions of “major swap participant” [750] and “major security-based swap participant” [751] (collectively, “major participant”) encompass any person that is not a swap dealer or security-based swap dealer [752] and that satisfy any one of three alternative statutory tests that encompass a person: (i) That maintains a “substantial position” in swaps or security-based swaps for any of the major swap categories as determined by the Commissions; (ii) whose outstanding swaps or security-based swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; [753] or (iii) that 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 maintains a “substantial position” in outstanding swaps or security-based swaps in any major category as determined by the Commissions. [754] The first—and only the first—of those three statutory tests explicitly excludes: (i) Positions held for “hedging or mitigating commercial risk,” and (ii) positions maintained by any employee benefit plan as defined in sections 3(3) and (32) of ERISA for the “primary purpose of hedging or mitigating any risk directly associated with the operation of the plan.” [755]

The statutory definitions require the Commissions to define the term “substantial position” at the threshold determined to be prudent for the effective monitoring, management, and oversight of entities that are systematically important or can significantly impact the financial system of the U.S. In setting these thresholds, the Commissions are required to consider the person's relative position in uncleared as opposed to cleared swaps and may take into consideration the value and quality of collateral held against counterparty exposures. [756]

The statutory definitions further permit the Commissions to limit the scope of the major participant designations so that a person may be designated as a major participant in certain categories of swaps or security-based swaps, but not all categories. [757]

In addition, the “major swap participant” definition excludes certain entities whose primary business is providing financing and that use derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company. [758] The “major security-based swap participant” definition does not contain this type of exclusion.

As detailed in the Proposing Release, the major participant definitions focus on the market impacts and risks associated with a person's swap and security-based swap positions. [759] This is in contrast to the definitions of “swap dealer” and “security-based swap dealer,” which focus on a person's activities and account for the amount or significance of those activities only in the context of the de minimis exception. However, persons that meet the major participant definitions in large part must follow the same statutory requirements that will apply to swap dealers and security-based swap dealers. [760] In this way, the statute applies comprehensive regulation to entities whose swap or security-based swap activities do not cause them to be dealers, but nonetheless could pose a high degree of risk to the U.S. financial system generally. [761]

Although the two major participant definitions are similar, they address instruments that reflect different types of risks and that can be used by end-users and other market participants for different purposes. Interpretation of the definitions must account for those differences as appropriate.

The Commissions in the Proposing Release proposed to further define the “major swap participant” and “major security-based swap participant” definitions, by specifically addressing: (i) The “major” categories of swaps or security-based swaps; (ii) the meaning of “substantial position”; (iii) the meaning of “hedging or mitigating commercial risk”; (iv) the meaning of “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; and (v) the meanings of “financial entity” and “highly leveraged.” The proposal also addressed the period of time that a major participant would have to register (as well as the minimum length of time for being a major participant), the limited purpose designations of major participants, the exclusion for ERISA plan hedging positions, and certain additional interpretive issues.

After considering commenters' views, the Commissions are adopting final rules further defining the meaning of major participant.

As discussed below, the Commissions also are directing their respective staffs to report separately as to whether changes are warranted to any of the rules implementing the major participant definitions. These staff reports will help the Commissions evaluate the “major swap participant and “major security-based swap participant” definitions, including whether new or revised tests or approaches would be appropriate for identifying major participants. [762]

A. “Major” Categories of Swaps and Security-Based Swaps

1. Proposed Approach

The first and third tests of the statutory major participant definitions encompass entities that maintain a substantial position in a “major” category of swaps or security-based swaps. [763]

In the Proposing Release, the Commissions proposed to designate four “major” categories of swaps and two “major” categories of security-based swaps. These categories sought to reflect the risk profiles of the various types of swaps and security-based swaps, and the different purposes for which end-users use those instruments. The Proposing Release also noted the importance of not parsing the “major” categories so finely as to base the “substantial position” thresholds on unduly narrow risks and reduce those thresholds' effectiveness as risk measures. [764]

The proposed four “major” categories of swaps were rate swaps, credit swaps, equity swaps and other commodity swaps. [765] Rate swaps would encompass any swap which is primarily based on one or more reference rates, such as swaps of payments determined by fixed and floating interest rates, currency exchange rates, or other monetary rates. Credit swaps would encompass any swap that is primarily based on default, bankruptcy and other credit-related risks related to, or the total returns on, instruments of indebtedness (including loans), including but not limited to any swap primarily based on one or more broad-based indices related to debt instruments, and any swap that is a broad-based index credit default swap or total return swap. Equity swaps would encompass any swap that is primarily based on equity securities, such as any swap primarily based on one or more broad-based indices of equity securities, including any total return swap on one or more broad-based equity indices. Other commodity swaps would encompass any swap not included in any of the first three categories, and would generally include, for example and not by way of limitation, any swap for which the primary underlying item is a physical commodity or the price or any other aspect of a physical commodity. The four categories were intended to cover all swaps, and each swap would be in the category that most closely describes the primary item underlying the swap. [766]

The Commissions proposed to designate two “major” categories of security-based swaps. [767] The first category would encompass any security-based swap that is based, in whole or in part, on one or more instruments of indebtedness (including loans), or a credit event relating to one or more issuers or securities, including but not limited to any security-based swap that is a credit default swap, total return swap on one or more debt instruments, debt swaps, or debt index swaps. The second category would encompass any other security-based swaps not included in the first category, including for example, swaps on equity securities or narrow-based security indices comprised of equity securities. [768] These proposed categories were based on the different uses of these types of security-based swaps, and were consistent with market statistics and infrastructures that distinguish between those types of security-based swaps. [769]

2. Commenters' Views

Certain commenters requested clarification regarding how the major categories would be applied. One commenter particularly requested additional clarity as to how the proposed categories will apply to mixed swaps and to swaps that are based on debt that is convertible to equity, [770] while another commenter requested additional clarity as to the status of certain mortgage-related transactions. [771]

One commenter suggested that the final rules should include a catch-all provision to allow the Commissions to review large positions that appear to be structured to evade proper categorization, and that market participants should suggest the protocols for categorization of swaps or security-based swaps. [772]

One commenter suggested that the rate swap category should be divided between interest rates and currencies, and that energy, agriculture and metals swaps should be separate categories. [773] Another commenter expressed the view that creation of a separate category for cross currency swaps could lead to confusion among market participants who may feel obligated to bifurcate cross currency swaps between two categories. [774] Some commenters expressed general support for the major categories as proposed. [775]

3. Final Rules

After considering the issue in light of comments received, the Commissions are adopting final rules designating “major” categories of swaps and security-based swaps consistent with the proposal. Accordingly, the final rules provide that the four “major” categories of swaps are rate swaps, credit swaps, equity swaps and other commodity swaps. [776] The two “major” categories of security-based swaps are debt security-based swaps [777] and other security-based swaps. [778]

The Commissions believe that it is not necessary to further divide the proposed categories or add new categories for swaps and security-based swaps for purposes of the major participant definitions. We believe that maintaining a large number of narrow categories of swaps and security-based swaps would increase the possibility of confusion by market participants with regard to categorizing the swaps and security-based swaps in which they transact. The Commissions also continue to believe that it is important not to parse the “major” categories so finely as to base the “substantial position” thresholds on unduly narrow groupings that would reduce those thresholds' effectiveness as risk measures. Categories that are broad and clearly delineated further should help prevent action to evade designation as a major participant in a particular “major” category.

While we believe that these rules in general are sufficiently clear to allow each swap and security-based swap to be placed in the appropriate category, we are mindful of the commenters' request for guidance with regard to certain circumstances. In the case of mixed swaps, we would expect that the instrument would be placed in the “swap” and “security-based swap” categories that are consistent with the underlying attributes that cause such instrument to be a mixed swap. [779] Also, swaps or security-based swaps that are based on more than one item, instrument or risk, should be placed in the category that most closely describes the primary item, instrument or risk underlying the swap or security-based swap. [780]

B. “Substantial Position”

1. Proposed Approach

The major participant definitions require that the Commissions define a “substantial position” in swaps or security-based swaps at a threshold that we determine to be “prudent for the effective monitoring, management, and oversight” of entities that are systemically important or can significantly impact the U.S. financial system. The definitions further require that we consider a person's relative position in uncleared and cleared swaps or security-based swaps, and permit us to consider the value and quality of collateral held against counterparty exposure. [781]

The proposed rules provided that a person would have a “substantial position” in swaps or security-based swaps if the daily average current uncollateralized exposure associated with its swap or security-based swap positions in a major category in a calendar quarter amounted to $1 billion or more (or $3 billion in the case of rate swaps). [782] A person also would have a “substantial position” if the daily average of the sum of the current uncollateralized exposure plus the potential future exposure associated with its positions in a major category in a calendar quarter amounted to $2 billion or more (or $6 billion for the rate swap category). [783]

The proposed rules did not prescribe any particular methodology for measuring current exposure or valuing collateral posted, and instead provided that the method used should be consistent with counterparty practices and industry practices generally. [784] The proposed rules also provided that an entity could calculate its current uncollateralized exposure by accounting for netting agreements on a counterparty-by-counterparty basis, [785] and the Proposing Release set forth a method for allocating any residual uncollateralized exposure to a counterparty that remains following netting. [786]

The proposed potential future exposure test was based on the risk-adjusted notional amount of the entity's swap and security-based swap positions, consistent with a test used by bank regulators for purposes of setting capital standards. [787] The test also excluded or lowered the potential exposure associated with certain lower-risk positions. [788] In addition, the measures of potential future exposure would be discounted by up to 60 percent to reflect the risk mitigation provided by netting agreements, [789] and would further be decreased by 80 percent for positions subject to central clearing or daily mark-to-market margining. [790]

2. Commenters' Views

a. Basis for Regulating Major Participants and Alternative Approaches for Identifying “Substantial Positions”

Several commenters expressed the view that the major participant definition is intended to address entities whose swap or security-based swap positions pose systemic risk, [791] while one commenter took the contrary view that the definition also is intended to address the significance of an entity's swap or security-based swap positions (as well as the risk those positions pose). [792]

One commenter stated that the proposal inappropriately sought to account for the risk posed by the potential default of multiple entities, rather than a single entity. [793] Some commenters suggested that the analysis should account for the concentration of the risk posed by an entity's positions, [794] and one commenter suggested that the analysis should not account for individual categories of swaps or security-based swaps. [795]

b. Levels of Proposed “Substantial Position” Thresholds

A number of commenters expressed the view that the proposed thresholds are inappropriately low. [796] Some commenters stated the thresholds initially should be high, with later revisions based on market data. [797]

Some commenters did not oppose the proposed thresholds or expressed support for the thresholds (though many of those commenters separately raised issues about the underlying tests), [798] while two commenters supported lowering the proposed thresholds. [799] Some commenters took the position that the thresholds should be adjusted over time to reflect factors such as inflation or market characteristics. [800]

c. Current Uncollateralized Exposure Test

Measures of exposure and valuation of collateral—A number of commenters supported the Proposing Release's position that the current exposure analysis not prescribe any methodology for measuring exposure or valuing collateral. [801] On the other hand, some commenters requested explicit approval of particular methodologies, [802] a good faith safe harbor, [803] or regulator-prescribed measurement standards. [804] Some commenters emphasized the need to be able to post non-cash collateral in connection with positions. [805] Two commenters requested codification of the proposal's position that operational delays associated with the daily exchange of collateral would not lead to current uncollateralized exposure for purposes of the analysis. [806]

Netting issues—Some commenters stated that the proposed netting provisions should be expanded to encompass additional products that may be netted for bankruptcy purposes. [807] One commenter took the view that these provisions should be expanded across multiple netting agreements to the extent that offsets are permitted. [808] One commenter asked for clarification as to the scope of the netting provisions, [809] and one commenter expressed general support for the proposed netting provisions. [810]

Allocation of uncollateralized exposure—Some commenters requested that the final rules incorporate the principles, articulated in the Proposing Release, for allocating any uncollateralized exposure that remains following netting. [811] Other commenters raised concerns that those principles were based on an unwarranted assumption that collateral is specifically earmarked to particular transactions. [812]

d. Potential Future Exposure Test

General concerns and suggested alternative approaches—Some commenters disagreed with the Proposing Release's statement that the potential future exposure analysis would evaluate potential changes in the value of a swap or security-based swap over the remaining life of the contract; those commenters stated that the test instead should focus on potential volatility during the time it would take for a non-defaulting party to close out a defaulting party's positions. [813]

Some commenters criticized the tables setting forth the risk adjustments used to calculate potential future exposure. [814] Commenters further suggested using, as alternatives, value-at-risk measures or other models, [815] or the “standardized method” under Basel II. [816] Commenters also argued that risk adjustments should provide a greater discount to credit swaps on “investment grade” instruments than to other credit swaps, that index CDS should be subject to a greater discount than single name CDS, and that there should be a lower discount factor for CDS of shorter maturity. [817] One commenter generally supported the proposed conversion factors and adjustments. [818]

Some commenters expressed the view that measures of potential future exposure should be superseded by negotiated independent amounts or regulator-required initial margin. [819] Some commenters also argued that excess posted collateral or net in-the-money positions should be offset against potential future exposure. [820]

Potential future exposure measures for lower-risk positions—Some commenters stated that the proposal to cap potential future exposure when a person buys credit protection using a credit default swap should be expanded to apply to any position with a fixed downside risk. [821] Commenters also suggested that the potential future exposure associated with purchases of credit protection be further discounted, [822] while one commenter took the position that purchases of credit default swaps should be excluded from the potential future exposure test. [823] Commenters also addressed the appropriate discount rate for calculating the net present value of unpaid premiums. [824]

Netting issues—One commenter stated that the proposal's netting provisions did not adequately account for the risk mitigation associated with hedged positions, [825] while another commenter asked that the proposed netting provisions be clarified and simplified. [826] One commenter supported the proposed netting approach. [827]

Discount for cleared or margined positions—Several commenters took the view that cleared positions should be excluded entirely from the potential future exposure analysis, rather than only being subject to an 80 percent discount, [828] and some commenters also supported a complete exclusion for positions subject to daily mark-to-market margining. [829] One commenter suggested a minimum 98 percent reduction for positions subject to central clearing or mark-to-market margining, [830] while one commenter suggested that there be a higher discount for positions subject to the posting of initial margin. [831]

Some commenters also stated that there should be a partial discount provided in connection with positions for which mark-to-market margining is done less than daily, [832] and that there should be a discount for positions that are margined using security interests or liens. [833] On the other hand, one commenter stated that there is no basis for providing any discount for marked-to-market positions. [834]

One commenter requested that the rule language codify language in the Proposing Release as to when a position is subject to daily mark-to-market margining. [835] A number of commenters addressed proposed rule language that was intended to clarify that the discount for daily mark-to-market margining would be available even in the presence of thresholds and minimum transfer amounts. [836]

Two commenters supported the proposed approach in general. [837] One commenter specifically supported the proposed 80 percent reduction for positions subject to daily mark-to-market margining, [838] and one commenter specifically supported a reduction for cleared positions. [839]

Additional issues regarding the potential future exposure test—Some commenters argued that the Commissions should clarify how the categories in the proposed potential future exposure tables would be applied, given how those differ from the proposed “major” categories of swaps and security-based swaps. [840]

Some commenters raised concerns that the proposed use of an instrument's “effective notional” amount is ambiguous. [841] Commenters also took the position that for purposes of the potential future exposure calculation, notional amounts should be adjusted to reflect delta weighting, [842] that the measure of duration for options on swaps should consider whether the underlying swap is cash-settled, [843] and that the adopting release should set forth examples of potential future exposure calculations. [844]

e. Cost Concerns

Some commenters emphasized the need to avoid an overbroad major participant definition, [845] and highlighted concerns about being subject to unnecessary regulation. [846]

f. Additional Issues

One commenter suggested there be an explicit presumption against imposing major participant (or dealer) regulation on end-users. [847] Some commenters requested that the current uncollateralized exposure test explicitly exclude cleared positions, net in-the-money positions, and fully collateralized out-of-the-money positions, [848] and one commenter also supported excluding those positions from the potential future exposure analysis. [849] That commenter also supported excluding swaps on government securities from the substantial position analysis. [850]

One commenter requested confirmation that dealers and major participants would not be required to compute, assist with, or verify computations for counterparties that may be major participants, and also that market participants can enlist third-party services to assist in performing the calculations. [851] One commenter requested clarification that the proposed focus on uncollateralized exposure does not mean that end-users themselves should not demand collateral from dealers. [852]

3. Final Rules

a. Guiding Principles

The final rules defining “substantial position” focus on identifying persons whose large swap and security-based swap positions pose market risks that are significant enough that it would be “prudent” to regulate those persons. In developing these rules we have been mindful of the costs associated with regulating major participants, and have considered cost and benefit principles as part of the analysis of what level of swap and security-based swap positions reasonably form the lower bounds for identifying when it would be “prudent” that particular entities be subject to monitoring, management and oversight of entities that may be systemically important or may significantly impact the U.S. financial system. [853]

The final rules implementing the “substantial position” definition follow the basic approach that the Commissions proposed, including the combined use of current exposure and potential future exposure tests. [854] While we have carefully considered the views of commenters who suggested alternative approaches, we have concluded that it is appropriate to adopt the basic approach that was proposed, as described below.

  • Focus on default-related credit risks. The final rules implement tests that seek to reflect the credit risk that a person's swap or security-based swap positions would pose in the event of default. In arguing that the analysis should consider factors in addition to default-related risks, commenters have noted that certain regulations applicable to major participants address business conduct issues that are distinct from systemic risk issues. [855] We nonetheless believe that the statutory definition of “substantial position” indicates that the analysis should focus on default-related credit risks, because a default-related approach is more closely linked to the statutory criteria that the definition focus on entities that are “systemically important” or can “significantly impact” the U.S. financial system than would be an approach that focuses on the potential for disruptive market movements. [856]
  • Failure of multiple entities close in time. The final rules that implement the “substantial position” definition seek to reflect the risks that would be posed by the default of multiple entities close in time. Although one commenter took the view that the purpose of major participant regulation is to prevent the credit exposure of a single person from having a systemic impact, [857] we do not believe that the major participant definitions should be construed so narrowly. The events of recent years demonstrate that market stress may lead to the failure and near-failure of multiple entities with large financial positions over a relatively short time period. We do not believe that it would be prudent or well-reasoned to presume that recent history cannot repeat itself, and to assume that future failures of entities with large financial positions will be isolated events.
  • Aggregate risk. The final rules address the aggregate risk posed by an entity's swap or security-based swap positions, rather than seeking to focus on principles of concentration (such as by using a threshold that addresses an entity's largest exposure to an individual counterparty) or on converse principles of interconnection. The statutory “substantial position” definition is specifically written in terms of market risk concerns (i.e.,“systemically important” and “can significantly impact the financial system of the United States”), and measures of aggregate risk appear to be best geared to reflect this standard. [858]
  • Use of objective, quantitative criteria. The final rules provide for a “substantial position” analysis that is based on objective, quantitative criteria that would permit a market participant to determine which level of swap or security-based swap positions would cause it to be a major participant. Although one commenter has suggested the use of a two-step approach that uses thresholds as a safe harbor and that would be accompanied by a second-level determination, [859] we do not believe that such an approach would be consistent with the statutory language or with principles of regulatory efficiency. [860] Accordingly, a person whose swap or security-based swap positions satisfy the applicable thresholds will be a major participant, with no further layer of review provided. [861]

b. Current Uncollateralized Exposure Test

Consistent with the proposal, the final rules implementing the “substantial position” definition include a test that accounts for the current uncollateralized exposure posed by an entity's swap or security-based swap positions in a major category. [862] This provides a measure of the amount of potential risk that an entity would pose to its counterparties if the entity currently were to default. [863]

As with the proposal, a person would apply this test by examining the positions it maintains with each of its counterparties in a particular major category of swaps or security-based swaps. For each counterparty, the person would determine the dollar value of the aggregate current exposure arising from each of its swap or security-based swap positions with negative value in that major category by marking-to-market using industry standard practices, and deduct from that amount the aggregate value of the collateral the entity has posted with respect to the swap or security-based swap positions. [864] The “aggregate uncollateralized outward exposure” would be the sum of those uncollateralized amounts over all counterparties with which the person has entered into swaps or security-based swaps in that major category. [865]

The final rules implementing this test largely are the same as the rules the Commissions proposed, but with certain modifications to address issues raised by commenters.

i. Measure of Exposure and Valuation of Collateral

Consistent with the proposal, the final rules do not prescribe any particular methodology for measuring current exposure or for valuing collateral posted, but instead require the use of industry standard practices. [866] In this regard we do not concur with commenter requests that we approve or prescribe particular methodologies, or provide a safe harbor for measures or valuations made in good faith. [867] Instead, it is appropriate that the final rules provide market participants with the flexibility to use the same methodologies that they use in connection with their business activities. Accordingly, we would expect entities to value current uncollateralized exposure based on the amounts that would be payable if the transaction were terminated.

To the extent the measure of exposure or the valuation of collateral is subject to other rules or regulations, we also would expect those measures and valuations for purposes of the major participant calculations to be consistent with those other applicable rules. [868] In addition, the “substantial position” analysis may take into account the posting of non-cash collateral to the extent that the posting of such collateral, and the valuation of that collateral, is consistent with industry standard practices or applicable regulation. [869]

ii. Netting

The final rules build upon the proposal with regard to the measure of uncollateralized current exposure in the presence of netting arrangements. In particular, to address commenter concerns these provisions have been modified from the proposal to account for the fact that two counterparties may have multiple netting agreements for which offsets are permitted, and to extend the netting principles to any financial instruments that may be netted for purposes of applicable bankruptcy law (rather than limiting those instruments to swaps, security-based swaps and securities financing transactions).

Accordingly, the final rules provide that an entity may calculate its exposure on a net basis by applying the terms of one or more master netting agreements with a counterparty. The entity may account for offsetting positions entered into with that particular counterparty involving swaps or security-based swaps as well as securities financing transactions (consisting of securities lending and borrowing, securities margin lending and repurchase and reverse repurchase agreements), and other financial instruments and agreements that are subject to netting offsets for purposes of applicable bankruptcy law, to the extent consistent with the offsets provided by those master netting agreements. [870] These revisions should permit the current uncollateralized exposure test to more accurately reflect the degree of credit risk that an entity poses to its counterparty in the event of default.

As discussed in the proposal, these netting provisions apply only to offsetting positions with a single counterparty. [871] The provisions do not extend to the market risk offsets associated with an entity's positions with multiple counterparties, because such offsets would not directly mitigate the risks that an individual counterparty would face in the event of the entity's default. [872]

iii. Allocation of Uncollateralized Exposure Following Netting

The final rules build upon the proposal by codifying the method, discussed in the Proposing Release, related to the allocation of any uncollateralized exposure that remains following netting and the posting of collateral. This type of allocation can be necessary because, with netting, it otherwise may not be possible to directly attribute residual uncollateralized exposure to a particular major category of swap or security-based swap. [873] Some commenters have requested that the final rules codify this method to provide more certainty to market participants. [874]

Accordingly, the final rules incorporate a formula which, for purposes of the substantial position analysis, provides that the amount of net uncollateralized exposure that is attributable to a particular major category of swap or security-based swap would be allocated pro rata in a manner that compares the amount of the entity's out-of-the-money positions in that major category to its total out-of-the-money positions in all categories that are subject to the netting arrangements with that counterparty. [875] This approach does not require that any collateral be specifically earmarked to particular swaps or security-based swaps, and can be followed so long as collateral is posted based on the net exposure associated with all instruments subject to the applicable netting agreements with that particular counterparty. [876]

iv. Application of Current Exposure Test to Cleared, Fully Collateralized or Net In-the-Money Positions

Although certain commenters have requested that the current uncollateralized exposure test explicitly exclude swap or security-based swap positions that are cleared, fully collateralized or net in-the-money, [877] the final rules do not provide such exclusions. As we recognized in the Proposing Release, centrally cleared swaps and security-based swaps are subject to mark-to-market margining that would largely eliminate the uncollateralized exposure associated with a position, effectively resulting in the cleared position being excluded from the analysis. [878] Also, by definition, fully collateralized positions are not associated with current uncollateralized exposure, and thus would be excluded from the analysis. As such, we do not believe that it would be necessary to explicitly exclude such positions from the analysis. [879]

Similarly, we do not believe that it is necessary for the rules to explicitly exclude net in-the-money swap or security-based swap positions. If an entity does not have any current uncollateralized exposure to a particular counterparty—after accounting for the entity's netting agreement with that counterparty and the posting of collateral—then the entity may disregard its positions with that counterparty for purposes of calculating current uncollateralized exposure. Otherwise, it is appropriate to consider the contribution of all swaps or security-based swaps to current uncollateralized exposure, as determined by the allocation methodology discussed above. [880]

c. Potential Future Exposure Analysis

The “substantial position” analysis also will consider an entity's “aggregate potential outward exposure,” which would reflect the potential exposure of the entity's swap or security-based swap positions in the applicable “major” category of swap or security-based swaps, subject to certain adjustments. [881] The final rules implementing this test in general follow the proposed approach, but have been revised to address commenter concerns.

i. Purpose Underlying the Potential Future Exposure Test

As discussed in the proposal, a potential future exposure test addresses the fact that a sole focus on current uncollateralized exposure could fail to identify risky entities until some time after they begin to pose the level of risk that should subject them to regulation as major participants. [882] A potential future exposure test would allow the substantial position analysis to account for this risk by addressing how the value of an entity's swap or security-based swap positions may move against the entity over time. [883]

Accordingly, consistent with the proposal, the final rules incorporate a potential future exposure test that seeks to estimate how much the value of swaps or security-based swaps might change against an entity over the remaining life of the contract. Although some commenters took the view that this test should only address potential volatility during the period of time it would take for a non-defaulting party to close out positions and liquidate collateral, [884] we believe that it is more appropriate for the analysis to consider the risks that swaps or security-based swap positions pose over the lives of those positions. An exclusive focus on short-term risks would fail to account for the possibility that an entity's large swap or security-based swap positions can readily produce large losses in adverse market circumstances, potentially leading either to large uncollateralized exposure (if the posting of collateral is not required), or to large collateral calls that may lead to the entity's default (or to calls for extraordinary action) and that can threaten non-defaulting parties with significant costs and challenges in connection with liquidating and replacing those positions. The analysis should give appropriate weight to those risks.

ii. Risk Multipliers

Subject to modifications addressed below, the final rules implementing the “substantial position” analysis incorporate a potential future exposure test based on the proposal's general approach of adjusting notional positions using risk multipliers. [885] This approach incorporates and builds upon tests used by bank regulators for the purposes of setting prudential capital. [886] Through this methodology, the final rules implement an objective approach that readily can be replicated by market participants.

Although some commenters have suggested the use of value-at-risk measures or internal models to evaluate potential future exposure, [887] we do not believe that such approaches would be well tailored to be implemented by a range of market participants, or would lead to comparable results across market participants with identical swap or security-based swap portfolios.

In adopting this approach, we are mindful of the significance of commenter concerns about the adequacy of the tables that set forth the risk multipliers that would be applied to notional positions. These comments address, among other issues: discontinuities in the tables; the failure to account for whether, and how much, a swap or security-based swap is in-the-money or out-of-the money; the failure of the multipliers applicable to interest rate swaps to distinguish between counterparties who pay floating rates and counterparties who pay fixed rates; the failure of the multipliers in the credit category to account for the volatility of the underlying instrument or the duration of the swap or security-based swap; the failure of the multipliers for equity and commodity swaps to distinguish between high-volatility and low-volatility stocks and commodities; the adequacy of how the test addresses diversification and correlation; the fact that the approach does not provide for delta weighting of options positions; and the fact that the factors do not distinguish between index and single-name credit default swaps. [888] While we acknowledge that it may be possible to develop revised risk multipliers that are more finely tuned to reflect relevant risk factors, at this time we believe that it would be most appropriate to implement the “substantial position” analysis by building upon an existing regulatory approach that is comparatively simpler to implement and leads to reproducible results, rather than seeking to develop a brand new approach. [889]

The final rules implementing the “major security-based swap participant” definition, however, modify the proposed risk multipliers in response to commenter concerns about how the “major” categories of security-based swaps should be applied to the risk multiplier categories. In particular, the final risk multiplier category for security-based swaps in the “equity and other” category encompasses all security-based swaps that are not credit derivatives, and the final rules eliminate the proposed category for “other” types of security-based swaps. [890]

iii. Potential Future Exposure Measures for Certain Lower-Risk Positions

Consistent with the proposal, the potential future exposure calculation will exclude purchases of options and other positions for which a person has prepaid or otherwise satisfied its payment obligations. [891] Also, in response to commenter concerns, the final rules expand on the proposal with regard to capping the potential future exposure associated with certain lower-risk swap and security-based swap positions. The final rules particularly cap—at the net present value of the unpaid premiums—the potential future exposure associated with positions by which a person buys credit protection using a credit default swap, and positions by which a person purchases an option for which the person retains additional payment obligations under the position. [892] This reflects the reduced risk associated with such positions. The final rules do not prescribe a particular discount rate for purposes of this analysis, and market participants instead should use a commercially appropriate discount rate.

In addition, to better align the results of the potential future exposure analysis with the risks that a person presents, the final rules have been modified from the proposal to also exclude swap or security-based swap positions for which, pursuant to regulatory requirement, a person has placed in reserve an amount of cash or Treasury securities that is sufficient to pay the person's maximum possible liability under the position, when the person is prohibited from using that cash or those securities without also liquidating the swap or security-based swap position. [893]

iv. Adjustments for Netting

Consistent with the proposal, and with the bank regulator standards that form the basis for these potential future exposure measures, the final rules provide that an entity may reduce the measure of its potential future exposure in a major category by up to 60 percent to reflect the risk mitigation effects of master netting agreements. We believe that this approach appropriately reflects the risk mitigating attributes of netting on potential future exposure. Moreover, in light of commenter requests for clarification of how these netting provisions would be applied, [894] the final rules have been revised from the proposal to provide that the risk reduction associated with netting should be estimated using the same pro rata allocation methodology that will be used to measure current exposure. [895]

v. Adjustments for Cleared and Margined Positions

The final rules also provide for the measure of potential future exposure to be adjusted in the case of swap and security-based swap positions that are centrally cleared or that are subject to daily mark-to-market margining. This is consistent with the purpose of the potential future exposure test, which is to account for the extent to which the current outward exposure of positions (though possibly low or even zero at the time of measurement) might grow to levels that can lead to high counterparty risk to counterparties or to the markets generally. The practice of the periodic exchange of mark-to-market margin between counterparties helps to mitigate the potential for large future increases in current exposure.

Consistent with the proposal, the final rules reflect this ability to mitigate risk by providing that the potential future exposure associated with positions that are subject to daily mark-to-market margining will equal 0.2 times the amount that otherwise would be calculated. However, in response to commenters' opinions about the risk-mitigating effects of central clearing, and the additional level of rigor that clearing agencies may have with regards to the process and procedures for collecting daily margin, the final rules further provide that the potential future exposure associated with positions that are subject to central clearing will equal 0.1 (rather than the proposed 0.2) times the potential future exposure that would otherwise be calculated. [896]

Although some commenters supported the complete exclusion of cleared positions from the potential future exposure analysis, [897] and we are mindful of the risk mitigating attributes of central clearing, we also recognize that central clearing cannot reasonably be expected to entirely eliminate counterparty risk. [898] We conclude, however, that the use of a 0.1 factor (in lieu of the proposed 0.2) would be appropriate for cleared positions, reflecting the strong risk mitigation features associated with central clearing, particularly the procedures regarding the collection of daily margin and the use of counterparty risk limits, while recognizing the presence of some remaining counterparty risk.

Moreover, although some commenters opposed any deduction from the measure of potential future exposure for uncleared positions that are margined on a daily basis, [899] we believe that the risk-mitigating attributes of daily margining warrant an adjustment given that the goal of the potential future exposure test is to account for price movements over the remaining life of the contract. [900] The use of a 0.2 factor also reflects our expectation that the risk mitigation associated with uncleared but margined positions would be less than the risk mitigation associated with cleared positions.

While higher or lower alternatives to the 0.1 and 0.2 factors may also be reasonable for positions that are cleared or margined on a daily basis, we believe that the factors of the final rules reasonably reflects the risk mitigating (but not risk eliminating) features of those practices. The final rules also retain and clarify provisions addressing when daily mark-to-market margining occurs for purposes of this discount. [901]

vi. Application of “Effective Notional” Amounts

Consistent with the proposal (as well as the rules implementing the de minimis exception to the dealer definitions), the potential future exposure test is based on the “effective notional” amount of the swap or security-based swap when the stated notional is leveraged or enhanced by the structure of the swap or security-based swap. [902]

Moreover, as discussed in the Proposing Release, [903] in the case of positions that represent the sale of an option on a swap or security-based swap (other than the sale of an option permitting the person exercising the option to purchase a credit default swap), we would view the effective notional amount of the option as being equal to the effective notional amount of the underlying swap or security-based swap, and in general we would view the duration used for purposes of the formula as being equal to the sum of the duration of the option and the duration of the underlying swap or security-based swap. [904]

vii. Treatment of Initial Margin or Overcollateralization

The final rules retain the proposed approach of not modifying the measure of potential future exposure to reflect collateral that a person has posted to its counterparty in excess of current exposure. Although we recognize that the posting of excess collateral may mitigate the future credit risk that the potential future exposure measure is intended to estimate, that mitigating effect is not certain, and any such mitigation may not reflect the full value of the excess collateral. Moreover, while we believe that the measure of potential future exposure associated with swap or security-based swap positions reasonably estimates the credit risk that may be posed by those positions for purposes of the substantial position analysis, we also recognize that particular positions may prove to pose a far higher amount of credit risk. [905] Given how the credit risk associated with a swap or security-based swap position can far exceed the associated measure of potential future exposure, we do not believe that it would be appropriate to offset that measure to account for overcollateralization. [906]

d. Thresholds

The final rules retain the proposed thresholds for the amount of current uncollateralized exposure and potential future exposure that will cause an entity to be deemed to be a major participant. Accordingly, for a person to have a “substantial position” in a major category of swaps, it would be necessary for that person to have a daily average current uncollateralized exposure of at least $1 billion (or $3 billion for the rate swap category), or a daily average current uncollateralized exposure plus potential future exposure of $2 billion (or $6 billion for the rate swap category). [907] To have a “substantial position” in a major category of security-based swaps, it would be necessary for the person to have a daily average current uncollateralized exposure of at least $1 billion, or a daily average current uncollateralized exposure plus potential future exposure of at least $2 billion. [908]

As the Proposing Release noted, the proposed thresholds sought to reflect: (i) The financial system's ability to absorb losses of a particular size; (ii) the recognition that it would not be appropriate for the substantial position test to encompass entities only after they pose significant risks to the market through their swap or security-based swap activity; and (iii) the need to account for the possibility that multiple market participants may fail close in time. [909] While some commenters took the position that the proposed thresholds were inappropriately low, those commenters did not present empirical data or analysis in support of that view. Moreover, the Commissions do not concur with the suggestion [910] that the major participant definitions can reasonably be read to require that we defer this rulemaking until we have gathered additional data. Instead, the definitions direct us to set a standard that is “prudent,” which is what we have sought to do.

Some commenters who supported an increase in the proposed thresholds attempted to support their positions via analogy to past events, with the most significant of these being an analogy to AIG Financial Products (“AIG FP”). [911] The analogy to AIG FP [912] actually argues against an increase in these thresholds, however, particularly given that the credit derivative portfolio that significantly contributed to the liquidity problems that AIG FP faced amounted to $72 billion in notional amount. [913] Under the final rules, in the presence of central clearing or daily marking to market it would take a credit derivative portfolio in excess of that amount to trigger the potential future exposure threshold under the “substantial position” analysis. [914] This indicates that the thresholds are not inappropriately low, particularly given our view that the major participant definition is intended to encompass entities before their swap or security-based swap positions pose significant market threats. [915] Conversely, while additional data and analysis may warrant a reduction of these thresholds in the future, commenters who supported a reduction in those thresholds have not persuaded us that the proposed thresholds should be lowered.

e. Additional Issues

The final rules applying the “substantial position” analysis and the major participant definitions generally apply to all types of swaps or security-based swaps that a person maintains. Although one commenter suggested that swaps on government securities should be excluded from the analysis, the rules will not provide such an exclusion. To the extent that a person presents credit risk as a result of swaps referencing government securities, there is no basis for disregarding that risk when determining whether the person is a major participant.

In addition, in light of one commenter's concern, [916] the Commissions believe that it is important to emphasize that these rules should not be interpreted to deter end-users from requesting margin from dealers or major participants who are their counterparties to swaps or security-based swaps.

Also, in light of a point raised by another commenter, [917] the Commissions note that these rules implementing the major participant definitions do not place any independent calculation or other obligations upon counterparties to potential major participants, and that the rules do not preclude a potential major participant from seeking the assistance of a third party to perform the relevant calculation.

C. “Hedging or Mitigating Commercial Risk”

1. Proposed Approach

a. General Availability of the Proposed Exclusion

The first test of the major participant definitions excludes positions held for “hedging or mitigating commercial risk” from the substantial position analysis. [918] In the Proposing Release, we preliminarily concluded that positions that hedge or mitigate a person's commercial risk may qualify for this exclusion regardless of whether the entity is financial or non-financial in nature. [919] That conclusion in part was prompted by the fact that the statutory major participant definitions do not explicitly make the exclusion unavailable to financial entities; in contrast to the Title VII exceptions from mandatory clearing requirements in connection with hedging commercial risk, [920] which explicitly are unavailable to financial entities. [921] The conclusion also was prompted by the presence of the third major participant test—which specifically applies the substantial position analysis to certain non-bank financial entities but (unlike the first test) does not exclude commercial risk hedging positions from the analysis. [922]

In the Proposing Release, we also preliminarily concluded that the question of whether an activity is commercial in nature should not be determined solely by a person's organizational status as a for-profit, non-profit or governmental entity, but instead should depend on whether the underlying activity is commercial in nature. [923]

The proposal did not preclude the exclusion from being available in connection with hedges of a person's “financial” or “balance sheet” risks. In addition, the proposal solicited comment as to whether the exclusion should extend to activities in which a person hedges an affiliate's risk.

b. Proposed Definition Under the CEA Exception

The proposed interpretation of “hedging or mitigating commercial risk” for purposes of the CEA's definition of “major swap participant” premised the exclusion on the principle that swaps necessary to the conduct or management of a person's commercial activities should not be included in the calculation of the entity's substantial position. [924]

The CFTC noted first that the phrase “hedging or mitigating commercial risk” as used with respect to the major swap participant definition is virtually identical to Dodd-Frank provisions granting an exception from the mandatory clearing requirement to non-financial entities that are using swaps to hedge or mitigate commercial risk. [925] Also noted was that although only non-financial entities that use swaps or security-based swaps to hedge or mitigate commercial risk generally may qualify for the clearing exemption, no such statutory restriction applies with respect to the exclusion for hedging positions in the first test of a major participant. We therefore concluded that positions established to hedge or mitigate commercial risk may qualify for the exclusion, regardless of the nature of the entity—i.e., whether or not the entity is financial (including a bank) or non-financial. [926]

The CFTC preliminarily believed that whether a position hedges or mitigates commercial risk should be determined by the facts and circumstances at the time the swap is entered into, and should take into account the entity's overall hedging and risk mitigation strategies. However, the swap could not be held for a purpose that is in the nature of speculation, investing or trading. We anticipated that a person's overall hedging and risk management strategies would help inform whether or not a particular position is properly considered to hedge or mitigate commercial risk. Further, the exclusion under the Proposing Release included swaps hedging or mitigating any of a person's business risks, regardless of the swap's status under accounting guidelines or the bona fide hedging exemption.

c. Proposed Definition Under the Exchange Act Exception

For purposes of the Exchange Act's “major security-based swap participant” definition, the proposed rule defining “hedging or mitigating commercial risk” would require that a security-based swap position be “economically appropriate” to the reduction of risks in the conduct and management of a commercial enterprise, where those risks arise from the potential change in the value of assets, liabilities and services connected with the ordinary course of business of the enterprise. [927] The Proposing Release stated that the SEC preliminarily planned to interpret the concept of “economically appropriate” based on whether a reasonably prudent person would consider the security-based swap to be appropriate for managing the identified commercial risk. It further stated that the SEC also preliminarily believed that for a security-based swap to be deemed “economically appropriate” in this context, it should not introduce any new material quantum of risks (i.e., it could not reflect over-hedging that could reasonably have a speculative effect) and it should not introduce any basis risk or other new types of risk (other than the counterparty risk that is attendant to all security-based swaps) more than reasonably necessary to manage the identified risk. [928]

The proposed rules further provided that the security-based swap position could not be held for a purpose that is in the nature of speculation or trading—a limitation that would make the exclusion unavailable to security-based swap positions that are held intentionally for the short term and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, including security-based swap positions that hedge other positions that themselves are held for the purpose of speculation or trading. [929] The proposal also provided that a security-based swap position could not be held to hedge or mitigate the risk of another security-based swap position or swap position unless that other position itself is held for the purpose of hedging or mitigating commercial risk. [930] Finally, the proposal would have conditioned the entity's ability to exclude these security-based swap positions on the entity engaging in certain specified activities related to documenting the underlying risks and assessing the effectiveness of the hedge in connection with the security-based swap positions. [931]

2. Commenters' Views

a. In General

Several commenters generally supported the broad concepts underlying the proposed rules for identifying hedges of commercial risk, and particularly supported the proposed use of an “economically appropriate” standard instead of the “highly effective” standard that is used to identify hedges for accounting purposes. [932] On the other hand, one commenter stated that the definition should incorporate all manner of risks associated with commercial operations, including interest rate and currency risks, risks from incidental activities to commercial activities and risks from financial commodities. [933] One commenter further stated that the definition should encompass positions that facilitate asset optimization and dynamic hedging. [934]

Commenters further stated that the exception should include any position taken as part of a bona fide risk mitigation strategy, [935] and that Congress included “mitigation” in the exception for the purpose of covering risk reduction strategies that may not clearly be hedges but mitigate risk. [936] Some commenters also criticized the Proposing Release's position equating the terms “hedging” and “mitigating.” [937] One commenter also expressed concern that entities would find it difficult to analyze their positions with respect to the Proposing Release's statement, in the context of the Exchange Act definition, that “economically appropriate” security-based swaps would not add a new quantum of risk. [938]

Conversely, some commenters suggested that the proposed interpretation was too broad, [939] and that a broad interpretation could allow evasion, [940] or permit corporate end users to accumulate very large positions without becoming major swap participants. [941] One commenter stated that to include “financial risks” within the exclusion's scope would be improper because a “commercial risk” is one that is inherent in a person's commercial activities, while interest rate and currency risks arise from choices about how a person structures and finances its operations. [942] Some commenters stated that the rule should not include hedging of financial risks because Congress deleted the reference in an earlier version of the Dodd-Frank Act to hedging of “balance sheet risk.” [943] One commenter urged that we consider using accounting hedge treatment or the bona fide hedging exemption as guideposts for determining the availability of the exclusion. [944] Commenters also raised concerns about differences between the proposed approaches under the CEA and Exchange Act definitions of the terms. [945]

One commenter suggested that the definition should be expanded to include as commercial risks the risks faced by government entities because their need to manage risk is no different than the need of commercial firms. [946] Additional commenters suggested that commercial risk be interpreted to include risks faced by non-profit firms. [947]

Some commenters also supported modification of the rule text for specific purposes such as including risks from “transmitting” to cover activities of electricity companies, [948] to encompass risks “arising from” an asset rather than just risks arising from changes in value of the asset, [949] and to encompass the use of swaps by structured finance special purpose vehicles to hedge interest rate risk in structured financing. [950]

b. Availability of Exclusion to Financial Entities

Several commenters supported making the exclusion available to financial companies. [951] Some commenters further stated that there should be no special limits on financial entities with regard to the exclusion, [952] and that commercial risk should be defined broadly to include all of the commercial activities of a person, whether or not those activities relate to financial or non-financial commodities. [953] Two commenters discussing the use of swaps by insurance companies stated that making the exclusion available to financial companies is consistent with CFTC practice in the futures markets, that there is no fundamental difference in how an insurance company or a commercial enterprise uses swaps to reduce its risk, and that commercial risk encompasses financial risk. [954] In addition, these commenters noted that insurance regulators allow insurance companies to use swaps to hedge risk. [955]

On the other hand, some commenters opposed allowing financial entities to avail themselves of the exclusion, arguing that there is no benefit from allowing a financial firm to avoid major participant regulation through the hedging exclusion, [956] that the exclusion would allow financial companies to engage in risky trades, [957] and that the exclusion should be narrowly interpreted to cover hedging of only risks related to products. [958]

c. Hedging Risks of Affiliates and Third Parties

Some commenters expressed support for allowing persons to take advantage of the hedging exclusion when they use swaps to hedge the commercial risks of affiliates or third parties. Some commenters suggested that a person that aggregates and hedges risk within a corporate group should be allowed to use the exclusion despite the fact that it is the affiliates' risks that are hedged. [959] One commenter further stated that providers of risk management services should be allowed to take advantage of the exclusion because they are hedging commercial risk on behalf of their clients. [960]

One commenter, on the other hand, stated that the exclusion should be read narrowly for captive finance companies because the hedging entity may have to liquidate positions rapidly without access to affiliate's funds. [961]

d. Hedge Effectiveness and Documentation

Many commenters suggested that the rule should not test hedge effectiveness, explaining that requiring demonstration of hedge effectiveness would impose a subjective standard and would not reduce systemic risk. [962] In this regard, some commenters that addressed the proposed procedural requirements in the Exchange Act definition argued that these procedures would place unnecessary regulatory burdens on entities not regulated under the Dodd-Frank Act. [963] Conversely, one commenter that supported testing hedge effectiveness stated that the subdivided parts of a hedge should line up exactly with the subdivided parts of the risk. [964]

Some commenters agreed that the relationship between hedging and risk should be documented. One commenter expressed the view that documentation would facilitate audits. [965] Others took the view that a person should be required to demonstrate that the hedge does not create additional risk, that the risk may be hedged by swaps, and that there is a link between the swap and the risk. [966]

Several commenters suggested that once initiated, a hedge should not be retested over time, regardless of whether the position continues to serve a hedging purpose. [967] Other commenters disagreed, stating that a position that is no longer a hedge should not be covered by the exclusion. [968]

e. Swaps That Hedge Positions Held for Speculative, Investment or Trading Purposes

Many commenters took the view that swaps or security-based swaps used to hedge positions held for speculative, investment or trading purposes should qualify as hedges of commercial risk. [969] A few commenters stated that speculation, investment and trading are fundamental to commercial activity, and thus cannot be differentiated from other types of commercial activity. [970] Other commenters suggested the exclusion should cover swap positions that hedge other swap or security-based swap positions that are not themselves hedging positions. [971] Some commenters asserted that trading is different from speculating (taking an outright view on market direction) and investing (entering into a swap for appreciation in value of the swap position), and that swaps held for “trading” should be able to qualify for the exclusion. [972]

Some commenters requested that the definition under the CEA clarify how swaps that qualify as bona fide hedges are treated for the major swap participant definition if the underlying position had a speculative, investment or trading purpose, [973] and clarify that while the hedging exclusion would not apply to swap positions that hedge other swap positions that are held for speculation or trading, the hedging provision would apply to swap positions that hedge other non-swap positions held for speculation or trading. [974] Commenters also requested that the final rules provide that the hedging exclusion be available for physical positions in exempt or agricultural commodities and arbitrage positions relating to price differences between physical commodities at different locations. [975] One commenter, on the other hand, suggested that even swap positions that hedge other swap positions which are not hedging positions should be treated as hedging commercial risk because they are risk reducing. [976]

Four commenters took the position that swaps held for a purpose that is in the nature of speculation, investing or trading should not qualify as hedges of commercial risk. [977] One commenter pointed out that experience has shown that market participants sometimes inaccurately characterize positions as hedges (e.g., the inaccurate characterization occurs because the nature of positions change over time), and that excluding swap positions that hedge speculative, investment or trading positions would be especially inappropriate for financial firms that frequently use swaps to speculate, invest or trade. [978] One commenter stated that any swap position hedging another swap position could never be considered to be hedging commercial risk because the second swap is only adjusting the first swap position, meaning that neither swap would be congruent with risk reduction. [979] Another commenter stated that the hedging exclusion should not cover any swap hedging a speculative position. [980]

3. Final Rules—General Availability of the Exclusions

As with the proposed rules, the final CEA and Exchange Act rules implementing this exclusion are different in certain regards to reflect the different ways that swaps and security-based swaps may be expected to be used to hedge commercial risk, as well as differences in existing regulations under the CEA and the Exchange Act. Notwithstanding these differences, the two rules follow parallel approaches and address certain key issues in similar ways.

a. Availability to Financial Entities

Consistent with the position we took in the Proposing Release, the final rules with regard to both major participant definitions do not foreclose financial entities from being able to take advantage of the commercial risk hedging exclusion in the first major participant test. This conclusion in part is guided by the fact that the statutory text implementing this hedging exclusion does not explicitly foreclose financial entities from taking advantage of the exclusion—in contrast to Title VII's exceptions from mandatory clearing requirements for commercial risk hedging activities. The conclusion also results from the need to avoid an interpretation that would cause the third major participant test to be redundant. [981]

In reaching this conclusion, we recognize that some commenters stated that there would be no benefit from allowing financial firms to avoid regulation as a major swap participant through the hedging exclusion, and that the exclusion should cover only risks related to non-financial commercial activities, or else the exclusion would allow financial companies to engage in risky transactions. [982] We believe that not allowing the exclusion to cover swaps or security-based swaps used for speculation or trading (or investments, in the case of swaps) will be sufficient to limit financial entities' ability to engage in risky transactions. We also are not persuaded that “commercial risk” should be limited to only risks related to non-financial activities.

We nonetheless recognize the significance of concerns that financial entities may seek to depict speculative positions as hedges to take advantage of the exclusion. We also are mindful of the need to give appropriate meaning to the term “commercial risk” within the exclusion. We believe that the standard set forth in the final rules, including the provisions that make the exclusions unavailable to swap or security-based swap positions of a speculative or trading nature (or investment purposes, in the case of swaps), apply the statutory test in a manner that appropriately addresses those other concerns. As discussed below, those standards limit the ability of financial entities to take advantage of the exclusion. [983]

b. Availability to Non-Profit and Governmental Entities

Under the final rules, a person's organizational status will not determine the availability of this hedging exclusion. The exclusion thus may be available to non-profit or governmental entities, as well as to for-profit entities, if the underlying activity to which the swap or security-based swap relates is commercial in nature.

c. Hedges of “Financial” or “Balance Sheet” Risks

Under the final rules, the exclusion is available to positions that hedge “financial” or “balance sheet” risks. While we recognize that some commenters oppose the exclusion of those positions, [984] we nonetheless believe that the exclusion would be impermissibly narrow if it failed to extend to the “financial” or “balance sheet” risks that entities may face as part of their commercial operations, given that those types of risks (e.g., interest rate and foreign exchange risks) may be expected to arise from the commercial operations of non-financial end-users of swaps and security-based swaps. We do not believe the exclusion was intended to address those risks differently from other commercial risks, such as risks associated with the cost of physical inputs or the price received for selling products. [985]

d. Hedging on Behalf of an Affiliate

The final rules further provide that the exclusion is not limited to the hedging of a person's own risks, but also would extend to the hedging of the risks of a person's majority-owned affiliate. [986] This approach reflects the fact that a corporate group may use a single entity to face the market to engage in hedging activities on behalf of entities within the group. In our view, it would not be appropriate for the swap or security-based swap positions of the market-facing entity to be encompassed within the first major participant test if those same positions could have been excluded from the analysis if entered into directly by the affiliate. [987] Of course, the exclusion will only be available to the market-facing entity if the position would have been subject to the exclusion—e.g., not for a speculative or trading purpose—had the affiliate directly entered into the position.

4. Final Rules—“Major Swap Participant” Definition Under the CEA

a. In General

The general scope of the rule regarding “hedging or mitigating risk” will be adopted substantially as proposed. [988] The CFTC, however, is adopting CFTC Regulation § 1.3(kkk) with a modification to paragraph (1)(iii) to include a reference to qualified hedging treatment for positions meeting Government Accounting Standards Board (“GASB”) Statement 53, Accounting and Financial Reporting for Derivative Instruments. The CFTC believes that this minor modification to CFTC Regulation § 1.3(kkk) is necessary in order to include swaps that qualify for hedging treatment issued by GASB. [989]

As noted above, the CFTC will not prohibit financial companies from using the hedging exclusion because the exclusion for positions held for hedging or mitigating commercial risk set forth in CEA section 1a(33)(A)(i)(1) does not limit its application based on the characterization or status of the person or entity. Unlike the end-user clearing exemption of section 2(h)(7), the major swap participant hedging exclusion is not foreclosed to financial entities. [990] In addition, the hedging exclusion will extend to entities hedging the risks of affiliates in a corporate group, but not to third parties outside of a corporate group.

Like the proposed rule, the final rule under the CEA does not require a demonstration of hedge effectiveness, periodic retesting or specific documentation in order to apply the hedging exclusion from the definition of major swap participant.

b. Swaps That Hedge Positions Held for Speculation, Investment, or Trading

Swaps that hedge positions held for speculation, investment or trading will not qualify for the exclusion. In the Proposing Release, the CFTC explained that swap positions held for the purpose of speculation, investment or trading are those held primarily to take an outright view on market direction, including positions held for short term resale, or to obtain arbitrage profits. [991] Additionally, the Proposing Release stated that swap positions that hedge other positions that themselves are held for the purpose of speculation, investment or trading are also speculative, investment or trading positions. [992]

We note that some commenters suggested that swaps that hedge speculative, investment or trading positions should qualify for the exclusion because speculation, investment or trading are fundamental to commercial activity and cannot be differentiated from other types of commercial activity. Similarly, commenters that support allowing speculative, investment or trading positions to qualify for the exception stated that a swap hedging the risk of another swap (regardless of that swap's nature) is risk reducing and therefore hedges commercial risk. We believe that these commenters' interpretation of “commercial” is not consistent with congressional intent or the meaning of “commercial” in the Dodd-Frank Act with respect to the first test of the major participant definition or the end-user exception to the clearing mandate. We are unconvinced that allowing swap positions to qualify for the exception would be appropriate when used to hedge speculative, investment or trading positions because the swap would not hedge or mitigate the risks associated with the underlying position, or at least not in the manner intended by Congress. In addition, we believe that doing so would undermine the effectiveness of the major participant definition in that entities would be able to characterize positions for speculative, investment or trading purposes as hedges and therefore evade regulation as major participants.

Under CFTC Regulation § 1.3(kkk)(2)(i), swap positions executed for the purpose of speculating, investing, or trading are those positions executed primarily to take an outright view on market direction or to obtain an appreciation in value of the swap position itself, and not primarily for hedging or mitigating underlying commercial risks. [993] For example, swaps positions held primarily for the purpose of generating profits directly upon closeout of the swap, and not to hedge or mitigate underlying commercial risk, are speculative or serve as investments. Further, as an alternative example, swaps executed for the purpose of offsetting potential future increases in the price of inputs that the entity reasonably expects to purchase for its commercial activities serve to hedge a commercial risk.

The CFTC notes that the use of “trading” in this context is not used to mean simply buying and selling. Rather, a party is using a swap for the purpose of trading under the rule when the party is entering and exiting swap positions for purposes that have little or no connection to hedging or mitigating commercial risks incurred in the ordinary course of business. “Trading,” as used in CFTC Regulation § 1.3(kkk)(2)(i), therefore would not include simply the act of entering into or exiting swaps if the swaps are used for the purpose of hedging or mitigating commercial risks incurred in the ordinary course of business. [994]

The CFTC acknowledges that some swaps that may be characterized as “arbitrage” transactions in certain contexts may also reduce commercial risks enumerated in CFTC Regulation § 1.3(kkk)(1). The discussion in footnote 128 of the Proposing Release was intended to focus on clarifying that swaps are speculative for purposes of the rule if entered into principally and directly for profit and not principally to hedge or mitigate commercial risk. The reference to “arbitrage profits” in footnote 128 was intended to provide an example of what is commonly a speculative swap, not to characterize all arbitrage swaps as speculative.

c. “Economically Appropriate” Standard

The CFTC has determined to adopt the “economically appropriate” standard as proposed. We believe that this standard will help the CFTC and market participants distinguish which swaps are, or are not, commercial hedges thereby reducing regulatory uncertainty and helping prevent abuse of the hedging exclusion. CFTC Regulation 1.3(kkk)(1)(i) of the final rules enumerates specific risk shifting practices that are deemed to qualify for purposes of the hedging exclusion. [995] Whether a swap is economically appropriate to the reduction of risks will be determined by the facts and circumstances applicable to the swap at the time a swap is entered into. While we acknowledge that this standard leaves room for judgment in its application, we believe this flexibility is needed given the wide variety of swaps and hedging strategies the rule applies to. We believe the economically appropriate standard together with the identification of the six different categories of permissible commercial risks listed in final CFTC Regulation § 1.3(kkk)(1)(i) is specific enough, when reasonably applied, to distinguish whether a swap is being used to hedge or mitigate commercial risk.

The Commission has determined not to adopt a “congruence” standard because that standard may be too restrictive and difficult to use given the range of potential types of swaps and hedging strategies available.

5. Final Rules—“Major Security-Based Swap Participant” Definition Under the Exchange Act

a. “Economically Appropriate” Standard

The final rules retain the proposed “economically appropriate” standard, by which a security-based swap position that is used for hedging purposes [996] would be eligible for exclusion from the first major participant analysis if the position is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, when those risks arise from the potential change in the value of assets, liabilities and services in connection with the ordinary course of business of the enterprise. [997]

Consistent with the Proposing Release, we interpret the concept of “economically appropriate” to mean that the security-based swap position cannot materially over-hedge the underlying risk such that it could reasonably have a speculative effect, [998] and that the position cannot introduce any new basis risk or other type of risk (other than counterparty risk that is attendant to all security-based swaps) more than reasonably is necessary to manage the identified risks.

For example, a manufacturer that wishes to hedge the risk associated with a customer's long-term lease of a product may purchase credit protection using a single-name credit default swap on which the customer is the reference entity. The credit default swap may be excluded from the first major participant analysis even if it is for a shorter term than the anticipated duration of the lease so long as the use of such a shorter-term instrument is reasonable as a hedge, such as due to cost or liquidity reasons. [999] Also, the credit default swap may be excluded from the first major participant test if it hedges an amount of risk that is lower than the total amount of risk associated with the long-term contract. [1000]

In adopting this rule, we have considered commenter views that we should consider limiting the exclusion to positions that are recognized as hedges for accounting purposes. [1001] We nonetheless do not believe that the requirements that are appropriate to identifying hedging for accounting purposes are needed to limit the availability of the hedging exclusion. Moreover, linking the availability of the exclusion to accounting standards—which themselves may evolve over time—may lead the availability of the exclusion to evolve over time in unforeseen ways. We accordingly believe that the exclusion should be available if a security-based swap position is economically appropriate for hedging purposes (and not otherwise precluded from taking advantage of the exclusion).

We also have considered commenter concerns that the “economically appropriate” standard is too broad, [1002] and the additional suggestion that the exclusion instead should be limited to circumstances in which the hedge is “congruent” to the underlying risk. [1003]

We recognize the significance of commenters' concerns as to the practical application of the “economically appropriate” standard, particularly with regard to hedges that are not perfectly correlated with the underlying risk. [1004] The standard embeds principles of commercial reasonableness that should assuage those implementation concerns, however. These principles necessarily account for the fact that the reasonable use of security-based swaps to hedge a person's commercial risk may result in residual basis risk, and that the mere presence of this basis risk should not preclude the availability of the exclusion. Moreover, the mere presence of residual basis risk need not run afoul of the restriction against materially over-hedging the underlying risk, which is instead intended to prevent the hedging exclusion from applying to positions that are entered into for speculative purposes or that have speculative effect (such as by being based on a notional amount that is disproportionate to the underlying risk). [1005]

We also acknowledge that an “economically appropriate” standard does not provide the compliance assurance that would accompany quantitative tests or safe harbors. Nonetheless, grounding the hedging exclusion in principles of commercial reasonableness permits the standard to be sufficiently flexible to appropriately address an end-user's particular circumstances and hedging needs. Use of an “economically appropriate” standard also is consistent with the fact that entities should be expected to use their reasonable business judgment when hedging their commercial risks.

To provide additional guidance to entities hedging commercial risk, moreover, the final rule incorporates examples of security-based swap positions that, depending on the applicable facts and circumstances, may satisfy the “economically appropriate” standard. [1006] These are:

  • Positions established to manage the risk posed by a customer's, supplier's or counterparty's potential default in connection with: financing provided to a customer in connection with the sale of real property or a good, product or service; a customer's lease of real property or a good, product or service; a customer's agreement to purchase real property or a good, product or service in the future; or a supplier's commitment to provide or sell a good, product or service in the future. [1007]
  • Positions established to manage the default risk posed by a financial counterparty (different from the counterparty to the hedging position at issue) in connection with a separate transaction (including a position involving a credit derivative, equity swap, other security-based swap, interest rate swap, commodity swap, foreign exchange swap or other swap, option, or future that itself is for the purpose of hedging or mitigating commercial risk pursuant to the rule or the counterpart rule under the Commodity Exchange Act);
  • Positions established to manage equity or market risk associated with certain employee compensation plans, including the risk associated with market price variations in connection with stock-based compensation plans, such as deferred compensation plans and stock appreciation rights;
  • Positions established to manage equity market price risks connected with certain business combinations, such as a corporate merger or consolidation or similar plan or acquisition in which securities of a person are exchanged for securities of any other person (unless the sole purpose of the transaction is to change an issuer's domicile solely within the United States), or a transfer of assets of a person to another person in consideration of the issuance of securities of such other person or any of its affiliates;
  • Positions established by a bank to manage counterparty risks in connection with loans the bank has made; and
  • Positions to close out or reduce any of the positions addressed above.

b. Treatment of Speculative or Trading Positions

The final rule, consistent with the proposal, provides that this hedging exclusion does not extend to security-based swap positions that are in the nature of speculation or trading. [1008] The exclusion thus does not extend to security-based swap positions that are held for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, or to security-based swap positions that hedge other positions that themselves are held for the purpose of speculation or trading. [1009]

The Commissions recognize that some commenters take the position that the exclusion should extend to security-based swap positions that hedge speculative or trading positions. [1010] In support, these commenters have stated that the proposed approach would lead to more unhedged risk in the market, and that the proposed approach could lead entities that use security-based swaps to hedge speculative positions to be major participants, in contrast to unhedged (and presumably riskier) entities. Commenters further requested clarification regarding how entities may distinguish speculative or trading positions from other security-based swap positions. [1011]

The Commissions nonetheless do not believe that it would be appropriate to extend the hedging exclusion to speculative or trading positions, including security-based swap positions that themselves hedge other positions that are for speculative or trading purposes. Those limitations are appropriate to help give meaning to the concept of “commercial” risk, and to reflect the legislative intent to limit the impact of Title VII on commercial end-users of security-based swaps. [1012] Indeed, the use of security-based swap positions in connection with speculative and trading activity often may be expected either to have the purpose of locking-in arbitrage profits associated with those activities or producing an adjusted risk profile in connection with perceptions of future market behavior—neither of which would eliminate the speculative or trading purpose of the activity. [1013] We do not believe that it would be appropriate, or consistent with the Dodd-Frank Act, to interpret the term “commercial risk” to accord the same regulatory treatment to security-based swap positions for speculative or trading purposes as is accorded to the use of security-based swap positions in connection with commercial activities such as producing goods or providing services to customers. [1014]

Moreover, the Commissions believe that it would undermine the major participant definition to attribute a non-speculative or non-trading purpose to security-based swap positions that hedge speculative or trading positions. When a person uses a security-based swap position to help lock in profits or otherwise control the volatility associated with speculative or trading activity, or to cause that speculative or trading activity to reflect a particular market outlook or risk profile, the security-based swap position serves as an integral part of that speculative or trading activity. It thus would not appear appropriate or consistent with economic reality to seek to distinguish the security-based swap component from the other speculative or trading aspects of that activity. In fact, if “hedges” of speculative or trading positions were excluded from the first major participant test, entities could readily label a wide range of security-based swap positions entered into for speculative or trading purposes as being excluded hedges. [1015] Taken to its natural conclusion, such an approach largely may exclude security-based swap positions from the first major participant test, effectively writing that test out of the statutory definition.

We are aware of commenters' views that regulation of major participants has the potential to create a disincentive against certain entities' use of security-based swaps to manage risk in connection with their speculative or trading activities. [1016] Under this view, regulation potentially could result in those entities electing not to reduce the risks that they otherwise would seek to hedge, to avoid being regulated as major participants. [1017] That potential result, however, is an unavoidable consequence of the legislative decision to regulate persons whose security-based swap positions cause them to be major participants. It would not be appropriate to use the hedging exclusion to negate part of the underlying statutory definition simply to avoid disincentives that are an unavoidable consequence of the legislative decision to regulate major participants.

At the same time, we are mindful that market participants have requested further guidance as to how to distinguish between hedging positions that are subject to this exclusion, and speculative or trading positions that fall outside the exclusion. In our view, analysis of this issue is simplified by the nature of security-based swaps, and by the limited circumstances in which a person may be expected to have a commercial risk such that the use of a security-based swap may be economically appropriate for managing that commercial risk (rather than being for speculation or trading purposes).

In the case of security-based swaps that are credit derivatives, the final rule provides examples of the use of credit default swaps to purchase credit protection that, depending on the applicable facts and circumstances, may appropriately be excluded from the first major participant test (e.g., the use of a credit default swap to purchase credit protection in connection with the potential default of a customer, supplier or counterparty, or in connection with loans made by a bank). Certain other purchases of credit protection using credit default swaps—such as the purchase of credit protection to manage the risks associated with securities that a non-financial company holds in a corporate treasury and that are not held for speculative or trading purposes—may also meet the standard under these rules. [1018] The sale of offsetting credit protection may also reasonably be expected to fall within the exclusion to the extent that this sale is reasonably necessary to address changes (particularly reductions) in the amount of underlying commercial risk hedged by the initial security-based swap position. [1019]

As for security-based swaps that are not credit derivatives—such as equity swaps and total return swaps—the final rule provides examples of how the use of those security-based swaps in connection with certain business combinations may, depending on the applicable facts and circumstances, appropriately be excluded from the first major participant test. The use of equity swaps or total return swaps to manage the risks associated with securities that are held in a corporate treasury (and that are not held for speculative or trading purposes) may also appropriately be subject to the exclusion. Other uses of equity swaps or total return swaps to offset risks associated with long or short positions in securities, however, may not appropriately be excluded from the first major participant test, because such positions would be expected to have an arbitrage purpose or other speculative or trading purpose, and would be inconsistent with the “commercial risk” limitation to the hedging exclusion.

c. Treatment of Positions That Hedge Other Swap or Security-Based Swap Positions

The final rule, consistent with the proposal, provides that the hedging exclusion does not extend to a security-based swap position that hedges another swap or security-based swap position, unless that other position itself is held for the purposing of hedging or mitigating commercial risk. [1020] This provision allows the first major participant analysis to exclude a person's purchase of credit protection to help address the risk of default by a counterparty in connection with an interest rate swap, foreign exchange swap or other swap or security-based swap that the person has entered into for the purpose of hedging or mitigating commercial risk.

d. Procedural Conditions

In contrast to the proposal, the final rule does not incorporate procedural requirements in connection with the hedging exclusion from the first test of the major security-based swap participant definition. [1021] In making this change, we have been mindful of concerns that have been expressed that such procedural requirements would lead to undue costs in connection with hedging activity. [1022]

We understand, however, that many entities engaging in legitimate hedging of commercial risks do, as a matter of business practice, identify and document those risks and evaluate the effectiveness of the hedge from time to time. The presence of supporting documentation consistent with such procedures would help support a person's assertion that a security-based swap position should be excluded from the first major participant analysis, should the legitimacy of the exclusion become an issue.

Also, although we are not requiring the entity to monitor the effectiveness of the hedge over time, that absence of this requirement does not change the underlying need for a security-based swap position to be economically appropriate for the commercial risks facing the entity to be excluded from the first major participant definition. Thus, for example, if a person's underlying commercial risk materially diminishes or is eliminated over time, a security-based swap position that may have been economically appropriate to the reduction of risk at inception at a certain point in time may, depending on the facts and circumstances, no longer be reasonably included within the exclusion. [1023] As part of the reports required in connection with possible future changes to the major participant definitions, [1024] the staffs are directed to address whether the continued availability of the hedging exclusion should be conditioned on assessment of hedging effectiveness and related documentation.

D. Exclusion for Positions Held by Certain Plans Defined Under ERISA

1. Proposed Approach

The first statutory test of the major participant definitions excludes swap and security-based swap positions that are “maintained” by any employee benefit plan as defined in sections 3(3) [1025] and 3(32) [1026] of ERISA “for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan.” [1027]

The proposed rules incorporated that statutory exclusion without additional interpretation or refinement. [1028] In the Proposing Release, moreover, the Commissions expressed the preliminary view that we did not “believe that it is necessary to propose a rule to further define the scope of this exclusion.” We further noted that the exclusion for those plans identified in the statutory definition is not strictly limited to “commercial” risk, and that this may be construed to mean that hedging by those ERISA plans should be broadly excluded. The Commissions also solicited comment as to whether this exclusion should be made available to additional types of entities. [1029]

2. Commenters' Views

Some commenters requested clarification that the ERISA hedging exclusion is broader than the commercial risk hedging exclusion, and that the ERISA hedging exclusion can encompass positions that are not solely for hedging purposes. [1030] One commenter cautioned against interpreting the ERISA hedging exclusion broadly. [1031]

Commenters also requested that the Commissions clarify that the ERISA hedging exclusion applies to positions maintained by trusts that hold plan assets, [1032] or by pooled funds. [1033] One commenter, in contrast, stated that the exclusion should not be available to trusts holding plan assets. [1034]

One commenter stated that the exception should be extended to all public pension plans, [1035] and one commenter particularly took the view that the exclusion should be available to church plans. [1036] Some commenters stated that the exclusion should be available to non-U.S. plans. [1037]

3. Final Rules

Consistent with the position expressed in the Proposing Release, the Commissions interpret the ERISA hedging exclusion in the first statutory major participant test to be broader than that test's commercial risk hedging exclusion. This reflects the facts that the ERISA hedging exclusion is not limited to “commercial” risk, and that the ERISA hedging exclusion addresses positions that have a “primary” hedging purpose (which suggests that those positions may have a secondary non-hedging purpose).

a. Types of Excluded Hedging Activities

The Commissions are mindful of commenters' request for additional clarity regarding the scope of the ERISA hedging exclusion. In that regard, we note that we generally would expect swap or security-based swap positions to have a primary purpose of hedging or mitigating risks directly associated with the operation of the types of plans identified in the statutory definition—and hence eligible for the exclusion—when those positions are intended to reduce disruptions or costs in connection with, among others, the anticipated inflows or outflows of plan assets, interest rate risk, and changes in portfolio management or strategies.

Conversely, we believe that certain other types of positions would less likely have the primary purpose of hedging or mitigating risks directly associated with the operation of the plan, as anticipated by the statutory definition. [1038]

b. Availability of Exclusion

The Commissions recognize the significance of comments that these plans may use separate entities such as trusts or pooled vehicles to hold plan assets, and that the exclusion should not be interpreted in a way that deters the use of those vehicles. We believe that the same principles that underpin the exclusion for hedging positions directly entered into by the types of plans identified in the statutory definition also warrant making the exclusion applicable to plan hedging positions that are entered into by those other parties that hold assets of those types of plans. Otherwise, the major participant analysis would have the effect of deterring efficiencies in plan operations for no apparent regulatory purpose.

Accordingly, the Commissions interpret the meaning of the term “maintain”—in the context of the statutory provision that the swap or security-based swap position be “maintained by” an employee benefit plan—not only to include positions in which the plan is a counterparty, but also to include positions in which the counterparty is a trust or pooled vehicle that holds plan assets. Thus, for example, the exclusion would be available to trusts or pooled vehicles that solely hold assets of the types of plans identified in the statutory definition. [1039] The exclusion further may be available to entities that hold such plan assets in conjunction with other assets, but only to the extent that the entity enters into swap or security-based swap positions for the purpose of hedging risks associated with the plan assets. The exclusion does not extend to positions that hedge risks of other assets, even if those are managed in conjunction with plan assets. [1040]

The Commissions also are mindful of commenter concerns that the exclusion should explicitly be made available to other plans, such as church plans and non-U.S. plans. [1041] In this regard, the Commissions believe that the boundaries of the exclusion are set by the explicit statutory language, which states that it applies to any employee benefit plan as defined in paragraphs (3) and (32) of section 3 of ERISA. This reference is disjunctive—that is, a plan is eligible for the exclusion if it is within the scope of paragraph (3) (which refers to employee benefit plans) or of paragraph (32) (which applies to government plans). Accordingly, the scope of the cited definitions in paragraphs (3) and (32) should be determined in accordance with all law that applies in the interpretation of ERISA. [1042]

E. “Substantial Counterparty Exposure”

1. Proposed Approach

The major participant definitions' second statutory test encompasses persons whose outstanding swaps or security-based swaps “create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets.” [1043] In contrast to those definitions' first statutory test, which relates to persons with a “substantial position” in swaps or security-based swaps in a “major” category, [1044] this second test is not limited to positions in a single category. Also, unlike the first test, the second statutory test does not explicitly exclude certain commercial risk hedging positions or ERISA hedging positions.

For the “major swap participant” definition, the Proposing Release provided that a person's swap positions pose “substantial counterparty exposure” if those positions present a daily average current uncollateralized exposure of $5 billion or more, or present daily average current uncollateralized exposure plus potential future exposure of $8 billion or more. [1045] For the “major security-based swap” definition, the proposal provided that a person's security-based swap positions pose “substantial counterparty exposure” if those positions present daily average current uncollateralized exposure of $2 billion or more, or present daily average current uncollateralized exposure plus potential future exposure of $4 billion or more. [1046]

Under the proposal, those measures would be calculated in the same manner as would be used for the first major participant test, except that the “substantial counterparty exposure” analysis would consider all of a person's swap or security-based swap positions rather than solely considering positions in a particular “major” category, and that the “substantial counterparty exposure” analysis would not exclude positions to hedge commercial risks or ERISA plan risks.

The proposed “substantial counterparty exposure” thresholds were set higher than the proposed “substantial position” thresholds in part to reflect the fact that the former test accounts for a person's positions across four major swap categories or two major security-based swap categories. [1047] The proposed “substantial counterparty exposure” thresholds also reflected the fact that this second test (unlike the first major participant test) encompasses certain hedging positions that, in general, we would expect to pose a lesser degree of risk to counterparties and the markets.

2. Commenters' Views

a. General Comments

In light of the similarity between the proposed tests, a number of the concerns that commenters expressed with regard to the proposed “substantial position” definition also apply to the proposed “substantial counterparty exposure” definition. In addition, some commenters took the view that the proposed “substantial counterparty exposure” thresholds were too low, [1048] with several of those commenters stating that the thresholds should be raised to a level that reflects systemic risk. [1049] A few commenters took the view that the proposed thresholds were too high. [1050] Some commenters generally supported the approach to the definition of “substantial counterparty exposure” proposed by the Commissions. [1051]

Some commenters took the view that the “substantial counterparty exposure” test should focus on the size of an entity's exposure to specific counterparties. [1052] Several commenters suggested that the thresholds should be adjusted over time for inflation and changes in the swap and security-based swap markets. [1053] One commenter urged that the analysis consider the interconnectedness of the entity. [1054]

One commenter addressed the application of the second major participant test to insurance companies, arguing that substantial counterparty exposure should be decided by the FSOC in consultation with the relevant state insurance commissioner, and that hedges should be excluded from the calculation for insurers. [1055]

b. Lack of Exclusion for Hedging Positions

A number of commenters took the view that the second major participant test should exclude commercial risk hedging positions from the analysis. [1056] Some commenters also supported excluding ERISA hedging positions from the analysis. [1057] One commenter opposed any such exclusions for hedging positions. [1058]

3. Final Rules

Consistent with the Proposing Release, the final rules defining the term “substantial counterparty exposure” generally are based on the same current uncollateralized exposure and potential future exposure tests that are used to identify a “substantial position.” [1059] As with the Proposing Release, moreover, the “substantial counterparty exposure” analysis addresses all of a person's swap or security-based swap positions (rather than being limited to positions in a “major” category), and does not exclude hedging positions. [1060] The final rules also incorporate the quantitative thresholds that were proposed for those tests. [1061]

In adopting these final rules we have considered commenter views that the “substantial counterparty exposure” analysis should exclude certain commercial risk and ERISA hedging positions. We nonetheless believe that the structure of the major participant definitions—particularly the fact that those definitions specifically exclude hedging positions from the first statutory test but not from the second test—necessitates the conclusion that the second test not exclude those hedging positions.

We also have considered commenter views that the “substantial counterparty exposure” analysis should account for the maximum exposure that a person poses to any single counterparty. We nonetheless believe that the statutory test—particularly its focus on serious adverse effects on financial stability or financial markets—more appropriately is addressed by measures of the aggregate counterparty risk that an entity poses through its swap or security-based swap positions. Also, consistent with our views regarding the “substantial position” definition, we believe that the “substantial counterparty exposure” analysis appropriately is addressed via objective and quantitative criteria (rather than a multi-tier approach), and appropriately takes into account current uncollateralized exposure and potential future exposure.

Consistent with the Proposing Release, the thresholds to implement the second major participant test are higher than the corresponding thresholds for the first major participant test. These differences reflect the fact that the second test encompasses four “major” categories of swaps or two “major” categories of security-based swaps, as well as the fact that this second test does not exclude hedging positions that would appear to pose a lesser degree of counterparty risk than non-hedging positions.

While we are mindful of commenter views that the proposed “substantial counterparty exposure” thresholds were too low, [1062] we believe that the same principles that support the proposed standards in the context of the “substantial position” definition also support the proposed standards for this second test. As with the “substantial position” analysis, the “substantial counterparty exposure” analysis seeks to reflect a standard that encompasses large market participants before the counterparty risk posed by their swap and security-based swap positions present too large a problem, as well as the financial system's ability to absorb losses of a particular size, and the need to account for the possibility that multiple market participants may fail close in time. [1063] Commenters have not presented empirical or analytical evidence in support of a different standard. In the future, the Commissions may review and potentially adjust these thresholds to reflect evolving market structures and additional data.

F. “Highly Leveraged” and “Financial Entity”

1. Proposed Approach

The third statutory test of the major participant definitions encompasses any non-dealer that: (i) Is a “financial entity” (other than one that is “subject to capital requirements established by an appropriate Federal banking agency”), (ii) is “highly leveraged relative to the amount of capital it holds,” and (iii) maintains a “substantial position” in any “major” category of swaps or security-based swaps. [1064] In contrast to the first statutory test—which also encompasses persons with a “substantial position” in swaps or security-based swaps in a “major” category—this third test does not exclude positions that hedge commercial risk or ERISA risks.

a. “Financial Entity”

The Proposing Release defined the term “financial entity” for purposes of the major participant definition in the same general manner as Title VII defines that term for purposes of the end-user exemption from mandatory clearing, [1065] but with certain technical changes to avoid circularity. [1066]

b. “Highly Leveraged”

The Proposing Release set forth two alternative approaches for determining whether a particular entity would be deemed “highly leveraged.” [1067] Under one approach, an entity would be “highly leveraged” if the ratio of its liabilities to equity exceeded 8 to 1; this proposed alternative reflected the fact that the third statutory major participant test excludes certain types of entities. [1068] Under the alternative approach, an entity would be “highly leveraged” if the ratio of its liabilities to equity exceeded 15 to 1; this proposed alternative reflected standards for maximum leverage in certain circumstances found in Title I of the Dodd-Frank Act. [1069] The proposal further provided that leverage would be measured at the close of business on the last business day of the applicable fiscal quarter, and that liabilities and equity would be determined in accordance with U.S. generally accepted accounting principles (“GAAP”). [1070]

In proposing these alternative standards for identifying “highly leveraged” entities, the Commissions recognized that traditional balance sheet measures of leverage are limited as tools for evaluating an entity's ability to meet its obligations—in part because such measures do not directly account for potential risks posed by specific instruments held on the balance sheet, or for financial instruments held off of the balance sheet. At the same time, the Commissions preliminarily concluded that it was not necessary to use more complex measures of risk-adjusted leverage for these purposes, in part because the third test's “substantial position” analysis already accounts for such risks. The Commissions also noted the costs that would be associated with causing entities to engage in complex calculations of risk-adjusted leverage. [1071]

The Proposing Release solicited comment on a variety of issues related to the proposed leverage ratios, including the relative merits of the alternative 8 to 1 and 15 to 1 standards, and potential alternative standards. [1072]

2. Commenters' Views

a. “Financial Entity”

Some commenters recommended that certain types of entities should be excluded from the definition of “financial entity,” on the grounds that those types of entities are more appropriately treated as non-financial end users of swaps for purposes of the Dodd-Frank Act. [1073] Commenters specifically suggested that the “financial entity” definition exclude: (i) Centralized hedging and treasury subsidiaries in corporate groups; [1074] (ii) employee benefit plans; [1075] and (iii) cooperative structures. [1076] Commenters also requested clarification as to which entities would not be “subject to capital requirements established by an appropriate Federal banking agency,” and hence not subject to the third statutory test. [1077] In addition, commenters addressed the application of the “financial entity” definition to non-U.S. persons. [1078]

b. “Highly Leveraged”

A number of commenters supported the proposed 15 to 1 alternative leverage ratio over the 8 to 1 alternative, with some commenters further suggesting that the final rule should set a leverage ratio higher than 15 to 1, or that the ratio should be reconsidered when more information is available regarding leverage among swap users. [1079] One commenter supported the proposed 8 to 1 alternative, [1080] and one commenter suggested that the final rule should set a leverage ratio lower than 8 to 1. [1081] One commenter suggested a ratio of 12 to 1, consistent with certain capital requirements. [1082]

Commenters also suggested a variety of methods and adjustments for calculating leverage ratios. [1083]

Some commenters further suggested that specific leverage tests be applied to particular types of financial entities. For employee benefit plans, commenters particularly stated that a plan's obligations to pay benefits should not be considered a liability for purposes of the analysis, and the value of the plan's assets should be used as the denominator for the ratio in lieu of using the non-applicable term “equity.” [1084] Another commenter—which obtains a substantial amount of funding by issuing subordinated debt, rather than equity—expressed the view that the leverage calculation should allow it to treat subordinated debt as equity. [1085]

Several commenters addressed the application of the leverage ratio to insurance companies in light of the applicable regulatory regimes and their use of statutorily required accounting methods rather than GAAP. [1086] Those commenters took the view that an insurance company's leverage should be tested based on its risk-based capital ratio or on its statutory accounting statements, with certain adjustments to account for different types of liabilities, [1087] or based on whether its insurance regulator believes that it is adequately capitalized. [1088] One commenter said that the leverage ratio test should not apply to insurance companies, [1089] and another said that application of the leverage ratio test to insurance companies should be coordinated with the FSOC. [1090]

3. Final Rules

a. “Financial Entity”

Consistent with the Proposing Release, the final rules defining “financial entity” for purposes of the third major participant test are based on the corresponding “financial entity” definition used in the Title VII exception from mandatory clearing for end users, with certain adjustments to avoid circularity. [1091] In this regard, while we are mindful of one commenter's views that the differences between the major participant definitions and the end-user clearing exception necessitate different “financial entity” definitions, [1092] we do not concur with the view that the term “financial entity” should be interpreted independently in these two contexts. Both sets of provisions distinguish between financial and non-financial entities in a way that limits the impact of Title VII on the latter set of entities, and we believe that the definitions should be consistent in light of those parallel purposes.

The Commissions are aware, however, that the major participant definitions differ from the mandatory clearing requirements in how they address affiliates. The mandatory clearing requirements include a provision that specifically addresses affiliates of persons that qualify for the exception from mandatory clearing for end users, [1093] while no such specific provision is included in the major participant definitions. Given this absence, the Commissions believe it is appropriate to modify the final rules defining “financial entity” for purposes of the major participant definitions from the proposal to exclude certain centralized hedging and treasury entities. [1094] The Commissions understand that a primary function of such centralized hedging and treasury entities is to assist in hedging or mitigating the commercial risks of other entities within their corporate groups. Although those entities' activities could constitute being “in the business of banking or financial in nature,” we do not believe that it would be appropriate to treat a person as a “financial entity” for the purposes of the major participant definitions if the person would fall within that definition solely because it facilitates hedging activities involving swaps or security-based swaps by majority-owned affiliates that themselves are not “financial entities.” [1095] Absent this change, the major participant analysis would exclude hedging positions that do not use centralized hedging facilities, but would not exclude identical hedging positions that make use of a centralized hedging facility. [1096] Such a result would inappropriately discourage the use of centralized hedging and treasury entities.

While the Commissions also have considered the views of commenters that the “financial entity” definition should exclude certain other types of entities—such as employee benefit plans, and cooperatives—the final rules do not provide any such exclusions. As a general matter, the Commissions believe that the “financial entity” definition should be the same for purposes of the major participant definition as it is for purposes of the end-user exception from mandatory clearing. [1097]

We also have considered the views of some commenters that subsidiaries of bank holding companies, financial holding companies or systemically important financial institutions should be considered to be “subject to capital requirements established by an appropriate Federal banking agency,” and hence not subject to the third statutory major participant test. We nonetheless interpret the term “subject to capital requirements established by an appropriate Federal banking agency” to specifically apply to persons for whom a Federal banking agency directly sets capital requirements. We do not believe that the term should be interpreted to apply to other persons by virtue of their being part of a holding company that is subject to those capital requirements, or otherwise being affiliated with persons subject to those capital requirements, because we do not believe that the mere fact of that relationship is sufficient to control or mitigate the credit risk that those persons pose to their counterparties.

b. “Highly Leveraged”

i. Leverage Ratio Level

After considering commenters' views, the Commissions are adopting final rules that define “highly leveraged” to generally mean a ratio of liabilities to equity in excess of 12 to 1. [1098] Our adoption of this 12 to 1 standard, rather than the proposed 8 to 1 or 15 to 1 alternatives, takes into account commenters' views on the alternatives, as well as one commenter's support for a 12 to 1 ratio. [1099]

In general, we believe that the structure of the third statutory major participant test—which, unlike the first statutory test, does not permit the exclusion of certain hedging positions—reasonably may be interpreted as reflecting the determination that: (a) higher leverage indicates that an entity poses a heightened risk of being unable to meet its obligations; and (b) such entities should not be permitted to exclude hedging positions from the “substantial position” analysis in light of the counterparty risks those positions pose (even recognizing that these may be lower than counterparty risks posed by comparable non-hedging positions).

Commenters who addressed the proposed leverage ratio raised diverse points of view in support of the 8 to 1 and 15 to 1 alternatives, or other standards. A number of those commenters, however, appeared to focus on the outcome of particular leverage ratios—i.e., that a lower leverage ratio likely would lead to more major participants, and that a higher leverage ratio likely would lead to fewer major participants—and to base their conclusions on their views of that outcome. In general, the comments did not reflect an attempt to identify typical leverage ratios for financial entities, or to address the link between leverage and risk.

Some commenters specifically supported the use of a 15 to 1 leverage ratio in light of Title I's use of that ratio. [1100] While considering this perspective, we believe it also is appropriate to consider the different purposes for which leverage is addressed in the Title I and major participant contexts. The 15 to 1 leverage provision in Title I reflects a maximum allowable threshold of leverage for certain bank holding companies and nonbank financial companies when a determination has been made that such entities pose a “grave threat to the financial stability of the United States” and that the imposition of this limitation is necessary to mitigate the risks posed by such entities—in essence serving as a hard leverage cap for certain entities that have been deemed risky to the U.S. financial system. [1101] In contrast, leverage serves a type of gatekeeper function in the major participant definitions by identifying the amount of leverage that will require a non-bank financial entity to engage in the “substantial position” analysis without excluding hedging positions, rather than seeking to limit the maximum leverage available to those entities. Just as concepts of “maximum leverage” are distinct from concepts of “high leverage,” the use of a 15 to 1 maximum leverage ratio in Title I does not mandate the conclusion that the same 15 to 1 ratio must be used for interpreting the meaning of “highly leveraged” in the major participant definitions. [1102]

In considering the definition of the term “highly leveraged” based on the reasoning outlined above, we also are mindful that, as the Proposing Release noted, [1103] broker-dealer capital regulations include special provisions that apply when a broker-dealer's leverage exceeds 12 to 1. [1104] While we recognize that these capital regulations have limitations as tools for defining “highly leveraged” for purposes of the major participant definitions due to differences in how leverage would be calculated, [1105] we also believe that these regulations are informative regarding the use of leverage in the major participant context given that they highlight an existing link between increased regulatory oversight and the amount of leverage an entity maintains.

In light of the reasons noted above for using a leverage ratio below 15 to 1, commenter concerns that a ratio of 8 to 1 would be too low, one commenter's suggestion of a 12 to 1 leverage ratio, and leverage tests found in broker-dealer capital regulations, the Commissions have determined that a 12 to 1 leverage ratio reflects an appropriate basis for identifying “highly leveraged” financial entities. In making this determination we recognize that other approaches also may be reasonable (e.g., lower thresholds based on the analysis of the leverage of certain financial entities also may be reasonable, as may higher thresholds based on Title I and on other aspects of broker-dealer capital rules). We also recognize, however, that the need to implement the major participant definitions requires that we draw a line. In our view, a 12 to 1 ratio reflects a reasonable location for this line that is appropriate for purposes of the third major participant test, and that reasonably accounts for commenter concerns and the other considerations discussed above.

ii. Leverage Ratio Calculation

Consistent with the proposal, the final rules defining “highly leveraged” generally measure leverage as a ratio of a person's liabilities to equity, as determined in accordance with GAAP. [1106] Also, consistent with the proposal, these leverage ratios should be calculated as of the close of business on the last business day of the applicable fiscal quarter, as we do not believe there is any relevant difference among financial entities that would require timing variations.

In general, moreover, the Commissions believe that all types of financial entities should be subject to the same methods of measuring leverage, to facilitate the even application of the leverage test. At the same time, we are mindful of the significance of commenter concerns that calculating leverage as a ratio of liabilities to equity consistent with GAAP would lead to inappropriate results for certain types of financial instruments or financial entities.

We believe that these concerns are significant enough to warrant one modification of the proposed approach to measuring leverage. In particular, the final rules provide that certain employee benefit plans may: (i) Exclude obligations to pay benefits to plan participants from their measure of liabilities for purposes of the leverage calculation; and (ii) substitute the total value of plan assets for equity for purposes of the leverage calculation. [1107] We believe that this change will allow the measure of leverage to more appropriately reflect the risk that those entities pose.

Otherwise, we do not believe that it would be appropriate to depart from GAAP measures of equity and liabilities for purposes of identifying highly leveraged entities. [1108]

G. Application to Inter-Affiliate Swaps and Security-Based Swaps

1. Proposed Approach and Commenters' Views

In the Proposing Release, we stated that the major participant analysis should consider the economic reality of swaps and security-based swaps between affiliates, and preliminarily concluded that swaps or security-based swaps among wholly owned affiliates “may not pose the exceptional risks to the U.S. financial system that are the basis for the major participant definitions.” [1109]

A number of commenters concurred that swaps among affiliates should be excluded from the major participant analysis. [1110] At the same time, no commenters expressed support for the Proposing Release's suggestion that this interpretation be limited to transactions among wholly owned subsidiaries. Instead, several commenters expressed the view that the swaps or security-based swaps should not be counted for purposes of the major participant analysis when the counterparties are under common control, [1111] or otherwise are affiliates. [1112] One commenter suggested that the analysis exclude swaps or security-based swaps between entities that are under common control and whose financial statements are consolidated. [1113]

2. Final Rule

After considering commenters' views, we have concluded that the major participant definitions should not encompass a person's swaps or security-based swaps for which the counterparty is a majority-owned affiliate. As noted in our discussion of inter-affiliate activities in the context of the dealer definitions, market participants may enter into such inter-affiliate swaps or security-based swaps for a variety of purposes. When swaps and security-based swaps are entered into to allocate risk within a corporate group and do not pose a high likelihood of risk to the broader market—as we believe would be the case with majority ownership—we do not believe that their swaps and security-based swaps raise the systemic risk and other concerns that major participant regulation is intended to address. For this reason, we do not believe that this interpretation needs to be limited to swaps or security-based swaps among wholly owned affiliates, as the Proposing Release had indicated.

Accordingly, the final rules provide that a person may exclude particular swaps or security-based swaps from the analysis of whether the person is a major participant, so long as the counterparties to those swaps or security-based swaps are majority-owned affiliates. [1114]

In taking this approach, we have also considered alternatives suggested by commenters. For example, while one commenter suggested that we allow the exclusion of all swaps or security-based swaps between entities under common control, we believe that such an approach would be overly inclusive for the purpose of identifying transactions that should be excluded from the major participant analysis, given that common control by itself does not ensure that two entities' economic interests are sufficiently aligned. [1115] Also, one commenter suggested that the inter-affiliate exclusion should apply to swaps and security-based swaps between affiliates whose financial statements are consolidated, but, as we addressed in the context of the dealer definitions, we do not believe that the scope of this exclusion should be exposed to the risk of future changes in accounting standards. [1116]

H. Application to Positions of Affiliated Entities and to Guarantees

1. Proposed Approach

The Proposing Release expressed the preliminary view that when a parent is the majority owner of a subsidiary entity, the subsidiary's swap or security-based swap positions may be aggregated at the parent for purposes of the major participant analysis, on the grounds that the parent effectively is the beneficiary of the transaction. At the same time, the Proposing Release acknowledged that there could remain questions as to whether the requirements applicable to major participants—such as capital, margin and business conduct requirements—should be placed upon the parent or the subsidiary. [1117]

The Proposing Release solicited comment on a number of aspects of these issues, including whether attribution would be appropriate when there is less than majority ownership, or when a parent provides guarantees on behalf of its subsidiaries. The Proposing Release also solicited comment with regard to implementation issues. [1118]

2. Commenters' Views

A number of commenters expressed the view that the Commissions should not aggregate the positions of affiliates to the parent, arguing that legal separation should be respected unless there is some evidence that separate affiliates are being used to evade regulation. [1119] Other commenters took the view that aggregation of affiliates' positions may be appropriate in some circumstances, such as when aggregation would accurately reflect the structure of a corporate group or its participation in the derivatives market. [1120] One commenter recommended that if the Commissions choose to require the aggregation of affiliate positions for purposes of the major participant test, the Commissions also should provide a mechanism for entities to receive “disaggregation” relief upon a showing that the affiliates are acting autonomously. [1121]

Some commenters argued that positions should not be consolidated for purposes of the major participant analysis even when a parent guarantees the obligations of a subsidiary. [1122] Other commenters, however, expressed less opposition to aggregation in the presence of a guarantee or credit support. [1123]

Commenters also addressed the application of these principles to particular types of entities. Some commenters took the view that positions guaranteed by financial guarantors should not be attributed to those entities for purposes of the major participant analysis. [1124] Other commenters stated that the positions of a special purpose vehicle should not be aggregated with its sponsor where there is no recourse to the sponsor for the vehicle's obligations. [1125] One commenter requested clarification that positions of joint ventures would not be aggregated with those of another entity if the positions are not consolidated on the other entity's balance sheet. [1126] Commenters further took the view that ERISA plans should not be aggregated with those of plan sponsors for purposes of the major participant tests, noting that plans and sponsors are separate legal entities, file separate financial statements, are subject to separate regulatory schemes, and that plan sponsors are prohibited from providing credit support or guarantees to ERISA Title I plans. [1127]

Two commenters addressed operational compliance issues that would be raised if positions are aggregated for purposes of the major participant analysis. One commenter suggested that a corporate group that falls within the major participant definition due to its aggregate positions should be able to designate a single entity to undertake compliance on behalf of the other affiliates. [1128] Another commenter stated that when the aggregated positions of a corporate group results in major participant designation, the Commissions should exempt from major participant regulation all affiliates in the corporate group that otherwise would qualify for the end-user clearing exception. [1129]

3. Final Interpretation

After considering commenter concerns and the underlying issues, we are revising certain of the preliminary views we expressed in the Proposing Release. In particular, we no longer take the position that a subsidiary's swap or security-based swap position as a matter of course should be attributed to the subsidiary's majority-owner parent. Instead, consistent with the approach discussed below with regard to managed accounts, [1130] an entity's swap or security-based swap positions in general would be attributed to a parent, other affiliate or guarantor for purposes of the major participant analysis to the extent that the counterparties to those positions would have recourse to that other entity in connection with the position. Positions would not be attributed in the absence of recourse. [1131] We believe this approach in general appropriately reflects the risk focus of the major participant definitions by providing that entities will be regulated as major participants when they pose a high level of risk in connection with the swap and security-based swap positions they guarantee. [1132] Indeed, the events surrounding the failure of AIG FP highlights how the guarantees can cause major risks to flow to the guarantor. [1133]

Even in the presence of a guarantee, however, we do not believe that it is necessary to attribute a person's swap or security-based swap positions to a parent or other guarantor if the person already is subject to capital regulation by the CFTC or SEC (i.e., swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, FCMs and broker-dealers) or if the person is a U.S. entity regulated as a bank in the United States. Positions of those regulated entities already will be subject to capital and other requirements, making it unnecessary to separately address, via major participant regulations, the risks associated with guarantees of those positions. [1134]

We recognize that attribution of swap or security-based swap positions to a parent or guarantor for purposes of the major participant analysis can raise special issues with regard to operational compliance. These include, for example, issues as to the application of the transaction-focused requirements applicable to registered major participants (e.g., certain requirements related to trading records and transaction confirmations), given that the entity that directly is the party to the swap or security-based swap may be better positioned to comply with those requirements. For those transaction-focused requirements, we believe that an entity that becomes a major participant by virtue of swaps or security-based swaps directly entered into by others must be responsible for compliance with all applicable major participant requirements with respect to those swaps or security-based swaps (and must be liable for failures to comply), but may delegate operational compliance with transaction-focused requirements to entities that directly are party to the transactions. The entity that is the major participant, however, cannot delegate compliance duties with the entity-level requirements applicable to major participants (e.g., requirements related to registration and capital). [1135]

I. Application to Managed Accounts

1. Proposed Approach

The Proposing Release expressed the preliminary view that the major participant definitions should not be interpreted to cause asset managers or investment advisers to be major participants by virtue of the swap and security-based swap positions of the accounts that they manage. [1136] In addition, the Proposing Release expressed the preliminary view that the managed positions for which a person is a beneficial owner should be aggregated with the person's other positions for the purpose of determining whether the beneficial owner is a major participant. [1137]

2. Commenters' Views

Numerous commenters supported the view that the major participant definitions should not be construed to aggregate the accounts managed by asset managers or investment advisers when determining whether a manager or adviser itself is a major participant. [1138] One commenter requested that the final rules codify this principle. [1139]

Some commenters opposed the possibility that the swap or security-based swap positions of mutual funds would be attributed to fund investors for purposes of the major participant analysis, emphasizing that the fund is the entity that bears the credit exposure. [1140] Some commenters also opposed the possibility that a swap or security-based swap position of a managed account may be attributed to the account's beneficial owner when the counterparty to the position does not have recourse to the beneficial owner's assets. [1141]

One commenter encouraged the Commissions to consider developing anti-evasion measures if necessary, but cautioned that the rules should recognize that there are legitimate business reasons to structure separate, individually managed funds. [1142] Another commenter dismissed concerns that entities may spread assets among many asset managers or use separate trading agreements to avoid regulation. [1143]

In addition, commenters raised related issues regarding the potential attribution of positions for purposes of the major participant analysis. Some commenters expressed the view that insurance company separate accounts should be excluded from the major participant determination for the insurer, because those separate accounts generally are segregated from the insurance company's other accounts. [1144] Two commenters requested clarification as to how swap and security-based swap positions of funds with a “master-feeder” structure should be allocated for the major participant determinations. [1145]

3. Final Interpretation

Consistent with the approach set forth in the Proposing Release, the Commissions do not believe that it is necessary to consider the swap or security-based swap positions of the client accounts managed by asset managers or investment advisers when determining whether those entities are major participants. In reaching this conclusion we particularly are influenced by the fact that the statutory definitions specifically address entities that “maintain” substantial positions or “whose” outstanding swaps and security-based swaps create substantial counterparty exposure. Our conclusion also is influenced by the fact that it would not appear appropriate to impose certain regulations applicable to major participants (e.g., capital) upon those entities. [1146]

Separately, after carefully considering commenters' views and the purposes of major participant regulation, we are modifying the preliminary views expressed in the Proposing Release regarding the application of the major participant analyses to the beneficial owners of managed swap and security-based swap positions. In particular, we conclude that the major participant analysis that applies to the beneficial owners of those positions should focus on where the risk associated with those positions ultimately resides, given how the statutory major participant definitions focus on the risks posed by large swap or security-based swap positions. Thus, for example, if the counterparties to a swap or security-based swap position within a managed account have recourse only to the assets of that account in the event of default—and lack recourse to other assets of the beneficial owners—we do not believe that it would be appropriate to attribute that position to its beneficial owner. [1147] Conversely, to the extent that the counterparty to that position also has recourse to the beneficial owner, it would be appropriate to attribute the positions to the beneficial owner for purposes of the major participant analysis. [1148]

We believe that this general approach of attributing positions when recourse is possible also is applicable with respect to related issues raised by commenters, including issues related to insurance company separate accounts and master-feeder fund arrangements. For those situations the same principle would apply—positions within an account or entity may be attributed to another entity for purposes of the major participant analysis if the counterparties to those positions can seek recourse from that other entity.

J. Requests for Exclusion of Certain Entities From the Major Participant Definitions

1. Proposed Approach

In advance of the Proposing Release, a number of commenters argued that the Commissions should exclude various types of entities from the major participant definitions. [1149] While the proposed rules did not incorporate any such exclusions, the Proposing Release solicited comment as to potential exclusions for: Entities that maintain legacy portfolios, investment companies, ERISA plans, registered broker-dealers and/or registered FCMs, sovereign wealth funds, banks, state-regulated insurers, private and state pension plans, and registered DCOs or clearing agencies. [1150]

2. Commenters' Views

Several commenters supported categorical exclusions from the major participant definitions for various types of entities. Commenters particularly urged the Commissions to provide exclusions for:

  • Entities that maintain legacy portfolios of swaps and security-based swaps that are in run-off; [1151]
  • Registered investment companies and related investment advisers; [1152]
  • ERISA plans, other pension funds, and endowments; [1153]
  • Certain registered FCMs and broker-dealers. [1155]
  • Various types of non-U.S. persons, including: foreign governments and their agencies and instrumentalities (such as central banks, treasury ministries, export agencies and governmental financing authorities), [1157] international organizations and multilateral development banks, [1158] sovereign wealth funds, [1159] and non-U.S. entities subject to comparable foreign regulation. [1160]

Commenters articulated a range of rationales in support of such exclusions. These included arguments that particular types of entities: (i) Are unlikely to meet one or more of the major participant tests; [1161] (ii) already are subject to regulation (and in some cases are subject to prudential limits on their use of swaps or security-based swaps); [1162] (iii) do not pose systemic risk [1163] and/or the type of counterparty risk contemplated by Title VII; [1164] or (iv) do not raise concerns given that they would remain subject to the clearing, exchange trading, and reporting requirements of Title VII. [1165] Also, some commenters maintained that regulating non-U.S. entities as major participants would raise issues with respect to extra-territoriality, international comity and sovereignty. [1166]

In contrast to these requests, one commenter urged that the benefits arising from regulation of major participants be considered in determining whether to create carve-outs from the participant definitions that are not provided in the statute. [1167]

3. Final Rules

After considering the comments received and the underlying issues, the Commissions have determined not to provide categorical exclusions from the major participant definitions for the types of entities discussed by commenters.

a. Entities That Maintain Legacy Portfolios

Commenters that supported the exclusion of entities with legacy portfolios of swaps or security-based swaps emphasized that those portfolios are in run-off, and that those entities generally do not engage in ongoing swap or security-based swap activity. [1168] Several of those commenters further expressed concerns that imposing the regulations applicable to major participants—particularly margin and capital rules—upon these entities could cause them to default on their obligations and lead to market disruption. [1169]

In the view of the Commissions, the fact that these entities no longer engage in new swap or security-based swap transactions does not overcome the fact that entities that are major participants will have portfolios that are quite large and could pose systemic risk to the U.S. financial system.

We are mindful of the significance of concerns that regulating entities that maintain legacy portfolios has the potential to lead to defaults and disruption. We do not believe, however, that these concerns are best addressed by excluding those entities from major participant regulation. Instead, in adopting substantive rules applicable to major participants, the Commissions intend to pay particular attention to the special issues raised by the application of those rules to legacy portfolios. [1170] Moreover, to the extent that these types of concerns remain following the promulgation of those final substantive rules, the Commissions may entertain requests for relief or guidance on a case-by-case basis.

b. Other Domestic Entities

Commenters also raised concerns regarding duplicative regulation for entities that already are subject to other types of regulation (e.g., state-regulated insurers, SEC-regulated registered investment companies and broker-dealers, and CFTC-regulated registered FCMs). The final rules nonetheless provide no such exclusion. The Dodd-Frank Act provided for the regulation of major participants against the backdrop of existing state and federal regulation, without opting to categorically exclude particular types of entities. Indeed, the definitions explicitly anticipate that pension plans [1171] and banks [1172] —both of which are subject to existing regulation—may be major participants. Major participant regulation provides a regulatory structure prescribed by the Dodd-Frank Act to address the risks posed by entities whose swap or security-based swap positions are large enough to satisfy the major participant definitions. Other types of regulations to which these entities may be subject serve different objectives [1173] that are not substitutes for major participant regulation. [1174]

The Commissions expect that only a very few entities within a given category may meet the test of being a major swap participant—or even be close to the various thresholds for meeting that test. Entities that do not meet the thresholds of the major participant definitions do not need an exclusion from those definitions. Further, as noted elsewhere in this Adopting Release, the Commissions are permitting entities to rely on a “safe harbor” when their positions are far below any threshold for any particular quarter. Some of the entities for which exclusion has been sought may be expected to fall within the safe harbor. Those comparatively fewer entities that will be closer to a particular threshold, by contrast, should not be excused on a per se basis from completing the calculations set forth in these rules and, if the calculations demonstrate that the entity meets the test of a major participant, from compliance with the requirements for major participants set forth by Congress.

At the same time, the Commissions recognize the benefits of efficiently regulating major participants that are separately registered with and regulated by the CFTC or SEC (such as registered FCMs or broker-dealers). [1175] If any such registrants are required also to register as major participants, the CFTC and SEC would seek to coordinate their regulatory oversight as appropriate to achieve the independent purposes of major participant regulation and those separate regulatory requirements, while avoiding unnecessary duplication. [1176]

c. Foreign Entities

Commenters [1177] discussed the major participant definitions in the context of foreign governments and various entities related to foreign governments [1178] (i.e., foreign central banks, [1179] international financial institutions [1180] and sovereign wealth funds). The CFTC provides the following guidance with respect to the major swap participant definition and the swap dealer definition. [1181]

As an initial matter, foreign entities are not necessarily immune from U.S. jurisdiction for commercial activities undertaken with U.S. counterparties or in U.S. markets. [1182] In accordance with the general rule, a per se exclusion for foreign entities from the CEA's major swap participant or swap dealer definition, therefore, is inappropriate. A foreign entity's swap activity may be commercial in nature and may qualify it as a swap dealer or major swap participant. Registration and regulation as a swap dealer or major swap participant under such circumstances may be warranted. [1183] This is particularly true for foreign corporate entities and sovereign wealth funds, which act in the market in the same manner as private asset managers.

On the other hand, the sovereign or international status of foreign governments, foreign central banks and international financial institutions that themselves participate in the swap markets in a commercial manner is relevant in determining whether such entities are subject to registration and regulation as a major swap participant or swap dealer. Canons of statutory construction “assume that legislators take account of the legitimate sovereign interests of other nations when they write American laws.” [1184] There is nothing in the text or history of the swap-related provisions of Title VII to establish that Congress intended to deviate from the traditions of the international system by including foreign governments, foreign central banks and international financial institutions within the definitions of the terms “swap dealer” or “major swap participant,” thereby requiring that they affirmatively register as swap dealers or major swap participants with the CFTC and be regulated as such. [1185] The CFTC does not believe that foreign governments, foreign central banks and international financial institutions should be required to register as swap dealers or major swap participants.

K. Financing Subsidiary Exclusion From Major Swap Participant Definition

In connection with the definition of major swap participant, CEA section 1a(33)(D) excludes certain entities from the definition of a major swap participant whose primary business is providing financing and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company (the “captive finance company exception”). [1186] This provision of the Dodd-Frank Act is not applicable to major security-based swap participants.

1. Proposal

The Proposing Release restated the statutory captive finance company exception but did not further define or detail its scope or parameters. Accordingly, the CFTC did not propose a specific rule excluding certain financing subsidiaries from the definition of major swap participant in the Proposing Release.

2. Commenters' Views

Commenters generally believed that the captive finance company exception should be broadly construed to cover financing of products being sold by the parent company or its authorized dealers, financing of service and labor, financing of component parts and attachments, and other general financing of the distribution network. [1187] One commenter said the exception should be read narrowly, because the physical positions (in inventory, etc.) related to swaps may not be able to be liquidated to mitigate the risks of the swaps. [1188]

3. Final Rules

The CFTC believes that the exception set forth in CEA section 1a(33)(D) should be construed (consistent with the statute) to provide practical relief to those captive finance companies whose “primary business” is financing and who uses swaps for the purpose of hedging named underlying commercial risks related to interest rate and foreign currency exposures. As an initial matter, the Commission notes that a captive finance subsidiary or other similar entity is required to provide financing as its primary business, i.e., this is not a supplementary or complementary activity of the entity. [1189]

In connection with the exception, commenters generally focused on the second part of Section 1a(33)(D) of the CEA, requesting the CFTC to interpret the phrase “90% or more of which are manufactured by the parent company or another subsidiary of the parent company” to include component parts, attachments, systems and other products that may be manufactured by others but sold together with the company's products as well as attachments and labor costs that are incidental to the primary purchase. [1190]

The CFTC believes that the captive finance exception must be interpreted in a manner consistent with the intention of Congress. As a result, a person that seeks to fall within the exemption must be in the “primary business” of providing financing of purchases from its parent company. Consistent with this initial requirement, the CFTC maintains that the captive finance exception can be applied when this financing activity finances the purchase of the products sold by the parent company in a broad sense, including service, labor, component parts and attachments that are related to the products.

L. Implementation Standard, Re-Evaluation Period and Minimum Period of Status

1. Proposed Approach

The proposed rules provided that a person would be deemed to be a major participant upon the earlier of: (i) The date on which it submits a complete application for registration, or (ii) two months after the end of the quarter in which a person meets the definition of major participant. [1191]

The proposed rules also provided that a person that has met the criteria for designation as a major participant as a result of its swap or security-based swap activities in a fiscal quarter, but without exceeding any applicable threshold by more than 20 percent, would not immediately be subject to the timing requirements discussed above. Instead, the person would be subject to the timing requirements noted above as soon as its daily average swap or security-based swap positions over any fiscal quarter exceed any of the applicable daily average thresholds. [1192]

Finally, the proposed rules provided that a person would retain the status of a major participant if its swap positions or security-based swap positions do not fall below all of the thresholds for four consecutive quarters. [1193] At that time, such entity may de-register as a major swap participant or major security-based swap participant.

2. Commenters' Views

Some commenters took the view that the time for compliance should be more than two months. [1194] One commenter suggested that entities be given the flexibility to have an additional evaluation period if abnormal market events or price movements cause the failure of the first reevaluation. [1195] Some commenters further expressed the view that the minimum amount of time a person would have to be registered as a major participant would be two quarters, rather than four quarters. [1196]

3. Final Rules

a. Timing

Consistent with the proposal, the final rules provide that a person would be deemed to be a major participant upon the earlier of the date on which it submits a complete application for registration, or two months after the end of the quarter in which it meets the criteria to be a major participant. [1197] In adopting these rules, the Commissions are mindful of commenters' concerns that market entities be given an adequate amount of time to come into compliance with the requirements applicable to major participants. At the same time, it is important to recognize that a person may submit a completed application for major participant registration prior to the time in which it must come into compliance with the requirements applicable to major participants. [1198] We believe that two months provides a reasonable amount of time for a person to submit a completed application for registration as a major participant. [1199]

b. Re-Evaluation Period

Consistent with the proposal, the final rules provide that if any entity meets the criteria for qualifying as a major participant, but does not exceed any applicable threshold by more than 20 percent in that particular quarter, the entity will not immediately be subject to the timing requirements noted above, but will become subject to the timing requirements at the end of the next fiscal quarter if such entity exceeds any of the applicable daily average thresholds in that next fiscal quarter. [1200] We believe that this standard will appropriately help to avoid applying major participant requirements to entities that meet the major participant criteria for only a short time due to unusual activity. [1201]

c. Minimum Period of Status

Consistent with the proposal, the final rules provide that a person would retain major participant status until it does not exceed any of the applicable thresholds for four consecutive quarters following registration. [1202] We believe that this time period appropriately addresses the concern that persons may move in and out of major participant status on a rapid basis. While we recognize that some commenters requested that this period be reduced to two quarters, we believe that a shorter period likely would lead to administrative confusion and burdens, as a shorter time period may be expected to lead entities to move in and out of major participant status more frequently.

M. Calculation Safe Harbor

1. Proposed Approach and Commenters' Views

In the Proposing Release, we expressed the understanding that only a limited number of persons currently have swap or security-based swap positions of a size that potentially could cause them to fall within the major participant definitions. [1203] Without disagreeing with that view, some commenters expressed concern about the costs and burdens associated with performing the applicable calculations on a daily basis, particularly citing the calculations' complex nature. [1204] Certain commenters further suggested that participants in the swap and security-based swap markets may perceive an obligation to conduct the relevant calculations on a daily basis even if they are not reasonably likely to be major participants. Those commenters requested that the Commission adopt a safe harbor by which persons with swap or security-based swap positions below a certain notional threshold would not have to perform the major participant calculations, or by which persons would not have to perform those calculations more than monthly when the results of those calculations are significantly below the levels required to be a major participant. [1205]

2. Final Rule

We continue to believe that under the rules we are adopting only a limited number of persons potentially may be major participants. Nonetheless, we recognize the significance of commenter concerns that some persons may perceive an obligation to conduct the major participant calculations as part of their compliance procedures even when there is not a significant likelihood that they would be major participants. We thus believe that a safe harbor can promote certainty and regulatory efficiency by helping market participants appropriately focus their compliance efforts and avoid undue compliance costs in circumstances when they would be highly unlikely to be major participants.

Accordingly, the Commissions are adopting a rule to incorporate a safe harbor into the major participant analysis. A person may take advantage of this safe harbor in any of three situations. First, a person will not be deemed to be a major participant if: (i) the express terms of the person's arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $100 million to all such counterparties, including any exposure that may result from the application of thresholds or minimum transfer amounts established by credit support annexes or similar arrangements; [1206] and (ii) the person does not maintain notional swap or security-based swap positions of more than $2 billion in any major category of swaps or security-based swaps, or more than $4 billion in aggregate. [1207]

Alternatively, a person will not be deemed to be a major participant if: (i) The express terms of the person's arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $200 million to all such counterparties, including any exposure that may result from thresholds or minimum transfer amounts; [1208] and (ii) the person performs the major participant calculations (e.g., the “substantial position” and “substantial counterparty exposure” calculations associated with the major participant tests) as of the end of every month, and the results of each of those monthly calculations indicate that the person's swap or security-based swap positions lead to no more than one-half of the level of current exposure plus potential future exposure that would cause the person to be a major participant. [1209]

Finally, a person will not be deemed to be a major participant if the person's current uncollateralized exposure is in connection with a major category of swaps or security-based swaps is less than $500 million (or less than $1.5 billion with regard to the rate swap category) and the person performs certain modified major participant calculations (e.g., the “substantial position” and “substantial counterparty exposure” calculations, simplified based on assumptions that are adverse to the person) [1210] as of the end of every month, and the results of each of those monthly calculations indicate that the person's swap or security-based swap positions in each major category of swaps or security-based swaps are less than one-half of the substantial position threshold. [1211] This test addresses the commenter suggestion that a safe harbor be set at one-half of the threshold triggering major participant designation. [1212] In addition, we have provided a more simplified alternate version of this test whereby a person will not be deemed to be a major participant if its monthly calculations indicate that the person's swap or security-based swap positions across all major categories of swaps or security-based swaps are significantly less than the substantial counterparty exposure threshold. [1213] This alternative provides a simple safe harbor for entities to apply without undertaking additional analysis to divide their swap or security-based swap positions into major categories. [1214]

In each of these circumstances, we believe that a safe harbor would be warranted because it would be sufficiently unlikely that the person's swap or security-based swap positions would cause the entity to be a major participant. [1215] The Commissions believe that for compliance purposes, persons should be able to rely on the proposed safe harbors noted above. This would benefit the swap and security-based swap marketplace and related market participants by avoiding unnecessary costs for various entities that, because of compliance concerns, would engage in major participant calculations even though it would be very unlikely that the major participant thresholds would be met.

The rule further provides that even if a person does not meet the conditions required to take advantage of the safe harbor, that fact by itself will not lead to a presumption that a person is required to perform the calculations required to determine if it is a major participant. [1216] This is consistent with the safe harbor's intent to promote certainty and efficiency in compliance efforts. While we are not prescribing when a person should perform the major participant calculations, participants in the swap and security-based swap markets should be mindful that they are responsible for determining whether they meet the major participant definitions, and that they will face liability if they knowingly or unknowingly meet one of those definitions without registering as a major participant.

N. Limited Designation as a Major Swap Participant or Major Security-Based Swap Participant

1. Proposed Approach

The “major swap participant” and “major security-based swap participant” definitions provide that the Commissions may designate a person as a major participant for a single category of swap or security-based swap. [1217] Unlike the limited designation provisions of the dealer definitions, the major participant definitions do not refer to limited designations in connection with particular swap and security-based swap activities. Also, unlike the dealer definitions (which refer to limited designations in connection with a particular “type,” “class” or “category” of swap or security-based swap), the major participant definitions specifically state that a person may be designated as a major participant for one or more “categories” of swap or security-based swap, without being a major participant for all “classes” of swap or security-based swap.

The proposal provided that a person who is a major participant in general would be considered to be a major participant with respect to all categories of swaps or security-based swaps, unless the person's designation is limited. [1218] We further stated that we anticipated that a major participant could seek a limited designation at the same time as its initial registration or at a later time, and we observed the difficulty of setting out the conditions that would allow a person to receive a major participant limited designation. [1219]

2. Commenters' Views

As discussed above, commenters generally addressed concerns regarding limited purpose major participant designations in conjunction with comments regarding limited purpose dealer designations. [1220] A few comments addressed these issues specifically in the context of the major participant definitions.

One commenter recommended that persons that exceed the first major participant threshold in a major category should presumptively be considered a limited major participant only for those categories of swaps or security-based swaps for which they crossed the threshold. [1221] Another suggested a similar approach when a major participant's swaps are concentrated in one major category. [1222] Two commenters suggested that limited major participant designations should not be confined to the proposed major swap categories. [1223]

3. Final Rules and General Principles Applicable to Limited Major Participant Designations

Consistent with the proposal, the final rules retain the presumption that a person that meets one of the major participant definitions will be deemed to be a major participant in connection with all categories of swaps or security-based swaps. [1224] As discussed in the Proposing Release, a person may apply for a limited designation when it submits a registration application, or later. [1225] The final rules also contain one change from the proposal, in that the provisions of the final rules related to limited major participant designation do not refer to the major participant's activities in connection with swaps or security-based swaps, in contrast to the proposal, because the relevant statutory provisions do not refer to limited designations related to activities.

Many of the principles discussed above in the context of limited designation of dealers also are relevant to the limited designation of major participants. Significantly, as with limited dealer designations, it is appropriate for major participants to be subject to a default presumption that they should be regulated as major participants for all of their swaps or security-based swaps. [1226]

Although a commenter suggested that different principles should apply in the context of the first major participant test [1227] —which is based on an entity's swap or security-based swap position in a single major category—we do not concur. The substantive requirements applicable to major participants do not contemplate treating entities that exceed the first and third thresholds of the major participant definition differently than those exceeding the second threshold. Instead, those requirements indicate that each entity that falls within the major participant definition must comply with registration and other substantive requirements triggered by such designation for all of its swap or security-based swap positions and activities. This conclusion also is supported by the fact that the limited designation authority provided to the Commissions is permissive rather than mandatory, and by the challenges of demonstrating compliance with the substantive requirements applicable to major participants in the context of a limited designation.

Indeed, as with limited dealer designation, one of the key requirements to overcoming the default presumption of full designation is an applicant's ability to comply with major participant regulation in the context of a limited designation. As with limited dealer designation, the Commissions will not designate a person as a limited purpose major participant unless the person can demonstrate compliance with the statutory and regulatory requirements applicable to major participants. Accordingly, an applicant to limited purpose designations must not only demonstrate the ability to comply with the transaction-level major participant requirements (e.g., certain business conduct standards and requirements related to trading records, documentation and confirmations) in the context of a limited designation, but also to entity-level major participant requirements (e.g., requirements related to registration, capital, risk management, supervision, and chief compliance officer).

V. Commission Staff Reports Back to Top

To review and evaluate the operation of the “swap dealer,” “security-based swap dealer,” “major swap participant” and “major security-based swap participant” definitions, the CFTC and SEC are directing their respective staffs to undertake future studies regarding the rules being adopted in connection with these definitions and the related interpretations. These studies will include the analysis of market data and the input of public comment.

The CFTC staff is further directed to report the results of this study to the CFTC on a date that is no later than 30 months following the date that a swap data repository first receives swap data under the CFTC's regulations. [1228] The SEC staff is further directed to report the results of this study to the SEC no later than three years following the later of: (i) the last compliance date for the registration and regulatory requirements for security-based swap dealers and major security-based swap participants under Section 15F of the Exchange Act; and (ii) the first date on which compliance with the trade-by-trade reporting rules for credit-related and equity-related security-based swaps to a registered security-based swap data repository is required. [1229] These staff reports will be made available for public comment.

A. Objectives of the CFTC Staff Report

In general, the CFTC's staff report—together with the associated public comment—is intended to help the CFTC thoroughly evaluate the practical implications and effects of the “swap dealer” and “major swap participant” definitions following the regulation of dealers and major participants under Title VII. In addition, the staff report is intended to assist the CFTC in evaluating whether new or revised tests or approaches would be appropriate for identifying swap dealers and major swap participants or for providing greater clarity as to whether particular entities do or do not fall within these definitions. The staff report is also intended to assist the CFTC more specifically in evaluating the potential implications of terminating the phase-in thresholds associated with the de minimis exception to the definition of a “swap dealer.”

To this end, the staff report generally should review each significant aspect of the rules being adopted in connection with the definitions and related interpretations. With respect to the “swap dealer” definition, such aspects include: (i) the factors associated with the definition (including the application of the dealer-trader distinction for identifying swap dealing activity); (ii) the extent of the exclusion of swaps entered into in connection with the origination of loans; (iii) the exclusion of certain swaps from the dealer analysis (i.e., swaps between affiliated parties, swaps between a cooperative and its members and swaps entered into for the purpose of hedging as defined in the rule); and (iv) the tests and thresholds used to implement the de minimis exception. With respect to the “major swap participant” definition, such aspects include: (i) The tests and thresholds associated with the “substantial position” definition; (ii) the definition of “hedging or mitigating commercial risk”; (iii) the tests and thresholds associated with the “substantial counterparty exposure” definition; and (iv) the definition of “highly leveraged”.

To facilitate this review, the CFTC staff report should address—as may be practicable in light of the data made available under the swap regulatory reporting regime or otherwise—a range of descriptive analytics that may be helpful in characterizing the nature of the swap market, its participants, and their activities. Such descriptive analytics could help inform the CFTC as to how the definitions in the final rules are being applied in practice and whether any adjustments to such definitions should be considered. For example, these analytics could indicate whether the population of registered swap dealers and major swap participants is substantially larger or smaller than expected, and, to some extent, what elements of the definitions are responsible for any significant differences. These analytics could also illuminate dynamics in the market that may require new or different treatment in the definitions. These analytics may also assist the CFTC in considering whether it would be practical and appropriate to apply new or different objective and readily verifiable tests or standards for determining whether particular entities are or are not swap dealers or major swap participants, including through the possible use of safe harbors, presumptions, thresholds, or defaults based on these tests or standards.

Depending on the availability and reliability of data and the developments in the market and regulatory framework, among other factors, the CFTC staff report could consider: how swaps differ among registered swap dealers, registered major swap participants and unregistered entities; differences among swaps in the major swap categories; differences among swap dealing activity of entities at various levels, including around the de minimis threshold; and estimates of quantitative information regarding use of swaps, including notional values, effective notional values, and collateralized and uncollateralized exposure.

The CFTC staff report should also address, as may be practicable, the nature and extent of the impact that the final rules and interpretations implementing the definitions have had on certain aspects of the swap market. Depending on the available information and other factors, the CFTC staff report could address the impact of these final rules and interpretations on competition in the swap market, market participants' ability to enter into swaps with various registered and unregistered entities, including IDIs, and the terms of swaps.

B. Objectives of the SEC Staff Report

In general, the report of the SEC staff—together with the associated public comment—is intended to help the SEC thoroughly evaluate the practical implications and effects of the dealer and major participant definitions following the regulation of dealers and major participants pursuant to Title VII. In addition, the staff report is intended to assist the SEC in evaluating whether new or revised tests or approaches would be appropriate for identifying dealers and major participants or for providing greater clarity as to whether particular entities do or do not fall within these definitions. The staff report also is intended to assist the SEC more specifically in evaluating whether it is necessary or appropriate to set higher or lower thresholds for the de minimis exception to the definition of “security-based swap dealer.”

To this end, the staff report generally should review each significant aspect of the rules being adopted in connection with the definitions and related interpretations. With respect to the security-based swap dealer definition, such aspects include: (i) The factors associated with the definition (including the application of the dealer-trader distinction for identifying dealing activity); (ii) the exclusion of inter-affiliate transactions from the dealer analysis (including the provisions limiting that exclusion to transactions among majority-owned affiliates); and (iii) the tests and thresholds used to implement the de minimis exception. With respect to the major security-based swap participant definition, such aspects include: (i) The tests and thresholds associated with the “substantial position” and “substantial counterparty exposure” definitions; (ii) the definition of “hedging or mitigating commercial risk” (including whether the definition inappropriately permits the exclusion of certain positions from the first test of the major participant definitions, and whether the continued availability of the exclusion should be conditioned on assessments of hedging effectiveness and related documentation); (iii) the definition of “highly leveraged”; and (iv) the exclusion of inter-affiliate transactions from the major participant analysis (including the provision limiting that exclusion to transactions among majority-owned affiliates).

C. Descriptive Analytics in the SEC Report

To facilitate this review, the report of the SEC staff should address—as may be practicable in light of the data made available under the applicable regulatory reporting regime or otherwise [1230] —a range of descriptive analytics that may be helpful in characterizing the nature of the security-based swap market, as well as entities within that market and those entities' activities. Such descriptive analytics could help inform the SEC as to how the definitions in the final rules are being applied in practice and whether any adjustments to such definitions should be considered. For example, these analytics could indicate whether the populations of dealers and major participants are substantially larger or smaller than expected, and, to some extent, what elements of the definitions are responsible for any significant differences. These analytics could also illuminate dynamics in the security-based swap market that may require new or different treatment in the definitions. For example, the analytics could indicate that the activity in certain segments of the security-based swap market—e.g., equity swaps—has significantly increased or decreased since the adoption of the final rules. These analytics may also assist the SEC in considering whether it would be practical and appropriate to apply new or different objective and readily verifiable tests or standards for determining whether particular entities are or are not dealers or major participants, including through the possible use of safe harbors, presumptions, thresholds or defaults based on these tests or standards.

The precise nature of the descriptive analytics included in the SEC staff report of course will depend on a number of considerations, including the availability and reliability of data and the developments in the market and regulatory framework. However, some salient candidates for descriptive analysis that could be considered at the time of the staff report include:

  • Characteristics of, and differences among, the security-based swap transactions and positions of three segments of participants in those respective markets—registered dealers, any registered major participants, and unregistered entities. [1231]
  • Characteristics of, and differences among, security-based swap transactions and positions connected with the broad product segments identified in the final rules (e.g., credit default swaps and other security-based swaps). [1232]
  • Characteristics of, and differences among, the apparent dealing activity of entities at various levels (including the $3 billion and $150 million de minimis levels established in the final rule in connection with the security-based swap dealer definition) based on their transactions and positions; [1233]
  • Characteristics of the security-based swap trading activity of “special entities”; [1234]
  • Characteristics of entities entering and exiting the security-based swap markets, using a variety of baselines; [1235]
  • Estimates of security-based swap entities' current uncollateralized exposure and potential future exposure at various levels of security-based swap positions; [1236] and
  • Estimates of security-based swap entities' ratios of total liabilities to equity. [1237]

D. Additional Analyses in the SEC Staff Report

To further facilitate this review, the SEC staff report should also address, as may be practicable, the nature and extent of the impact that the final rules and interpretations implementing the definitions have had on certain aspects of the security-based swap market. However, many economic, regulatory, and other factors—both related and unrelated to the implementation of Title VII—could impact the market going forward. The extent to which the staff report will be able to provide retrospective analyses regarding the effect of the definitions on the security-based swap markets (and the robustness of any such analysis) in significant part will be based on the nature and role of future exogenous factors that have also affected the market. Depending on these future factors and the potential challenges associated with addressing them in the staff reports, some salient candidates for retrospective impact analysis that could be considered at the time of the report include:

  • Effects on competition. The report may be able to explore connections between the definitions and the entry and exit of various entities in the security-based swap markets. For example, to what extent is an entity's entry or exit correlated with its registration status or its approaching or crossing any of the thresholds established by the definitions (e.g., the de minimis thresholds for dealers or the “substantial position” thresholds for major participants)? Has the current concentration of the dealer market dissipated, persisted, or strengthened over time? [1238]
  • Effects on investor protection. The report may be able to explore connections between the definitions and the nature and scope of transactions with certain classes of counterparties. For example, to what extent do unregistered entities in the security-based swap markets transact with counterparties such as “special entities,” natural persons, small businesses, or commercial entities? Have the nature and scope of trades by special entities or other classes of counterparties changed since 2011? Have unregistered entities—such as dealers operating under the de minimis threshold—emerged to engage in transactions with special entities or other particular classes of counterparties?
  • Effects on access. The report may be able to explore connections between the definitions and the ability of certain classes of counterparties to access products in the security-based swap market. For example, to what extent is an entity's registration status or its approaching or crossing any of the thresholds established by the definitions correlated with the entity ceasing transactions with certain classes or sizes of counterparties?
  • Effects of the dealer-trader distinction. The report may be able to explore connections between market dynamics and quantifiable metrics indicative of dealing activity. For example, are there identifiable, objective differences between the registered security-based swap dealers and unregistered market participant populations in terms of number of counterparties, buy/sell ratios, posting of initial margin, concentrations by counterparty or otherwise? If so, how does the amount of the activity (in terms of notional value and number of transactions) of those entities change when they move above or below the thresholds implied by those differences? How do the characteristics of their counterparties (in terms of number and nature) change?
  • Effects of de minimis thresholds. The report may be able to explore connections between market dynamics and the de minimis thresholds established by the definitions. For example, how does the amount of the activity (in terms of notional value and number of transactions) of security-based swap entities change when they move above or below the de minimis thresholds? How do the characteristics of their counterparties (in terms of number and nature) change?
  • Effects of major participant thresholds. The report may be able to explore connections between market dynamics and the major participant thresholds established by the definitions. For example, how have total notional security-based swap positions changed over time for large market participants that are not registered and that do not bear any indicia of dealing activity? For those large participants, have overall notional levels moved toward, or away from, the levels required to trigger the major participant thresholds?
  • Other effects of the definitions. To what extent do entities registered security-based swap dealers have overall trading characteristics suggesting that they may not be dealers? To what extent have entities not registered as dealers have trading characteristics suggesting that they may be acting as dealers? In either case, do any discrepancies between firms' registration status and their trading characteristics suggest any gaps or areas of uncertainty regarding the scope of the dealer definitions that may require potential modifications?

VI. Effective Date and Implementation Back to Top

Consistent with sections 754 and 774 of the Dodd-Frank Act, these final rules will be effective on 60 days following publication in the Federal Register. The Commissions, however, are providing for a phase-in period for persons engaged in dealing activity below certain amounts.

If any provision of these joint rules, or the application thereof to any person or circumstance, is held to be invalid, such invalidity shall not affect other provisions or application of such provisions to other persons or circumstances that can be given effect without the invalid provision or application.

A. CEA Rules

As explained below and as noted elsewhere in this Adopting Release, the compliance date for various regulatory requirements is contingent upon the adoption and effectiveness of other, related, regulatory provisions and definitions. Because the CFTC believes that the suite of rules implementing the Dodd-Frank Act are complex and interconnected, it has determined that implementation in certain cases can best be accomplished through separate rulemakings. The Commissions received comments related to implementation and phase-in that largely resulted from the CFTC's re-opening of the comment period for several rulemakings, and a request for comment on the order in which it should consider final rulemakings made under the Dodd-Frank Act. [1239] The CFTC notes that swap dealers and major swap participants will require an implementation or compliance period based on separate registration and regulatory requirements that are the subject of separate rulemakings by the Commission. [1240]

As the CFTC stated recently in another rulemaking related to CPOs:

[while t]he [CFTC] recognizes that entities will need time to come into compliance with the [CFTC]'s regulations * * * [b]ased on the comments received indicating that a certain portion of entities currently claiming relief [from CPO registration] under § 4.13(a)(4) already have robust controls in place independent of [CFTC] oversight, the [CFTC] believes that entities currently claiming relief under § 4.13(a)(4) should be capable of becoming registered and complying with the [CFTC]'s regulations within 12 months following the issuance of the final rule. For entities that are formed after the effective date of the rescission, the Commission expects the CPOs of such entities to comply with the Commission's regulations upon formation and commencement of operations. [1241]

The Commissions are taking the same approach with respect to implementing CFTC Regulations §§ 1.3(m)(5) and 1.3(m)(6). The loss of ECP status for Forex Pools currently operating other than pursuant to the retail forex regime of a federal regulator described in CEA section 2(c)(2)(E)(i) [1242] may involve significant structural and operational changes. The loss of a commodity pool's ability to rely on CEA section 1a(18)(A)(v) if it does not fall within CEA section 1a(18)(A)(iv) may require significant structural and operational changes. Because additional time may enable a Forex Pool affected by CFTC Regulation § 1.3(m)(5) to restructure to avoid being subject to the retail forex regime (e.g., by redeeming U.S. non-ECP participants) and may allow a commodity pool affected by CFTC Regulation § 1.3(m)(6) time to satisfy the terms of CEA section 1a(18)(A)(iv) (e.g., by the pool's CPO registering as such or claiming an exemption therefrom or by the pool raising its level of total assets above $5 million), the Commissions are delaying the effective date of CFTC Regulations §§ 1.3(m)(5) and 1.3(m)(6) until December 31, 2012, which is the compliance date for commodity pools no longer permitted to claim exemption from CPO registration pursuant to recently withdrawn CFTC Regulation 4.13(a)(4). [1243]

CFTC Regulation § 1.3(m)(8) conditions ECP status in part on a requirement that a commodity pool be “formed and operated” by a registered CPO or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3). Due to the revocation of CFTC Regulation § 4.13(a)(4), the Commissions anticipate that many CPOs will be registering as such in the future. However, the compliance date for registration for CPOs required to register as such due to the withdrawal of CFTC Regulation § 4.13(a)(4) is December 31, 2012. Furthermore, such CPOs may have formed the commodity pools that they currently operate when such CPOs were not registered as such.

Consequently, compliance with the formation element of CFTC Regulation § 1.3(m)(8)(iii) is not required with respect to a commodity pool formed prior to December 31, 2012. To be clear, however, while pools in existence before December 31, 2012 need not have been formed by a registered CPO, or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3), in order to satisfy the formation aspect of CFTC Regulation § 1.3(m)(8)(iii), such commodity pools nevertheless must be operated by a registered CPO, or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3), on December 31, 2012 to satisfy the “operated by a registered CPO” element of CFTC Regulation § 1.3(m)(8)(iii).

B. Exchange Act Rules

Because the SEC has not yet promulgated final rules implementing the substantive requirements imposed on dealers and major participants by Title VII of the Dodd-Frank Act, persons determined to be dealers or major participants under the regulations adopted in this Adopting Release need not register as such until the dates provided in the SEC's final rules regarding security-based swap dealer and major security-based swap participant registration requirements, and will not be subject to the requirements applicable to those dealers and major participants until the dates provided in the applicable final rules. [1244]

Moreover, as discussed above in the context of the de minimis exception to the security-based swap dealer definition, [1245] the SEC is making an extended compliance period available to persons engaged in dealing activity involving credit default swaps between $3 billion and $8 billion in trailing annual notional amount, and to persons engaged in dealing activity involving other types of security-based swaps between $150 million and $400 million in trailing annual notional amount. Persons taking advantage of that extended compliance period will be deemed not to be security-based swap dealers during that period, and will not be subject to registration requirements and other requirements associated with status as a security-based swap dealer during that period.

The SEC previously provided limited exemptive relief in connection with Exchange Act section 6(l), [1246] added by the Dodd-Frank Act, which prohibits any person from effecting a security-based swap transaction with a person that is not an ECP, unless effected on a national securities exchange. That relief expires as of the effective date of final rules further defining ECP. [1247] Accordingly, following the effective date of these final rules, dealers and major participants—and all other persons—will be subject to the prohibition of section 6(l) under the definition of ECP as amended by Title VII and as further defined by the rules. [1248]

VII. Administrative Law Matters—CEA Revisions (Definitions of “Swap Dealer” and “Major Swap Participant,” and Amendments to Definition of “Eligible Contract Participant”) Back to Top

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (“RFA”) requires Federal agencies to consider the impact of its rules on “small entities.” [1249] A regulatory flexibility analysis or certification typically is required for “any rule for which the agency publishes a general notice of proposed rulemaking pursuant to” the notice-and-comment provisions of the Administrative Procedure Act, 5 U.S.C. 553(b). [1250] In its proposal, the CFTC stated that “[t]he rules proposed by the CFTC provide definitions that will largely be used in future rulemakings and which, by themselves, impose no significant new regulatory requirements. Accordingly, the Chairman, on behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that the proposed rules will not have a significant economic impact on a substantial number of small entities.” [1251]

In response to the Proposing Release, one commenter stated that the CFTC's “rule-makings [are] an accumulation of interrelated regulatory burdens and costs on non-financial small entities like the NFPEEU members, who seek to transact in energy commodity swaps only to hedge the commercial risks of their not-for-profit public service activities.” [1252] In general, the commenter said that since the Small Business Administration (“SBA”) has determined that many rural electric cooperatives are “small entities” for purposes of the RFA, if the definition of swap dealer were to cover a substantial number of rural electric cooperatives the rule further defining swap dealer may have a significant economic impact on a substantial number of small entities. [1253] Thus, the commenter concluded that the CFTC should conduct a regulatory flexibility analysis for each of its rulemakings under the Dodd-Frank Act, including this rulemaking.

The commenter also said that the requirement in section 2(e) of the CEA, as amended by the Dodd-Frank Act, that a person who is not an ECP must execute swaps on a designated contract market would have the potential to have a significant economic impact on a substantial number of small entities if a substantial number of rural electric cooperatives were not covered by the definition of ECP. [1254] Another commenter said that in considering the economic impact on small entities of the swap dealer definition rules, the CFTC should consider whether the availability and cost of swaps to small entities could be affected by potential uncertainty among persons who engage in the activities covered by the definition about whether they are required to register as swap dealers. [1255]

The commenters did not provide specific information on how the further defining swap dealer would have a significant economic effect on a substantial number of small entities. Nonetheless, the CFTC has reevaluated this rulemaking in light of the statements made to it by these commenters. After further consideration of those statements, the CFTC has again determined that this final rulemaking will not have a significant economic effect on a substantial number of small businesses. With regard to the definition of swap dealer, the CFTC expects that if any small entity were to engage in the activities covered by the definition, most such entities would be eligible for the de minimis exception from the definition. [1256] Additionally, the Commission does not expect that the small entities identified by NFPEEU will be subject to registration with the Commission as a major swap participant, as most entities with total electric output not exceeding 4 million megawatt hours are not expected to maintain outstanding swap positions that would exceed the applicable thresholds. In general, the major swap participant definition applies only to persons with very large swap positions, and therefore the definition of major swap participant is incompatible with small entity status.

With regard to the definition of ECP, the CFTC notes that the costs of executing swaps on a designated contract market raised by the commenter arise from a requirement of the CEA, and not from any rule promulgated by the CFTC. Last, regarding the comment that there may be an economic impact on small entities in terms of the availability and cost of swaps, the definition of swap dealer is being adopted to limit uncertainty with respect to which entities will be required to register as a swap dealer. Thus, the definition of swap dealer is intended to avoid creating the substantial economic effect which concerns the commenter.

Accordingly, the Chairman, on behalf of the CFTC, certifies, pursuant to 5 U.S.C. 605(b), that the actions to be taken herein will not have a significant economic impact on a substantial number of small entities.

B. Paperwork Reduction Act

The Paperwork Reduction Act (“PRA”) [1257] imposes certain requirements on Federal agencies in connection with their conducting or sponsoring any collection of information as defined by the PRA. The Proposing Release stated that the proposed rules would not impose any new recordkeeping or information collection requirements, or other collections of information that require approval of the Office of Management and Budget (“OMB”) under the PRA, and invited public comment on the accuracy of the CFTC's estimate that no additional recordkeeping or information collection requirements or changes to existing collection requirements would result from the proposed rules. [1258]

One commenter said that the regulatory requirements imposed on swap dealers and major swap participants (including swap end users that may potentially be misclassified as swap dealers or major swap participants) will entail reporting and record keeping requirements. [1259] Specifically, the commenter noted that the CFTC stated in the Proposing Release that “any entity determined to be a swap dealer or major swap participant would be subject to registration, margin, capital, and business conduct requirements * * * all activities that will have associated reporting and additional recordkeeping requirements.” [1260] Another commenter said that the CFTC should consider the implications under the PRA of all of its rulemakings under the Dodd-Frank Act as a whole. [1261]

As with the proposed rules, these final rules will not impose any new information collection requirements that require approval of OMB under the PRA. All reporting and recordkeeping requirements applicable to swap dealers and major swap participants instead result from other rulemakings, for which the CFTC has sought OMB approval. The CFTC submitted an information collection request to OMB for each proposed rulemaking containing reporting or recordkeeping requirements, including the recordkeeping and reporting requirements referenced by the first commenter, [1262] which estimated the implications of the proposed collections on prospective respondents. [1263]

Moreover, in appropriate rulemakings, the CFTC sought to rely upon information collections that already had been proposed, in order to avoid imposing unnecessary additional burdens upon prospective respondents. [1264] Parties wishing to review the CFTC's information collections on a global basis may do so at www.reginfo.gov, at which OMB maintains an inventory aggregating each of the CFTC's currently approved information collections, as well as the information collections that presently are under review.

C. Cost Benefit Considerations

CEA section 15(a) requires the CFTC to consider the costs and benefits of its action before promulgating a regulation under the CEA, specifying that the costs and benefits shall be evaluated in light of five broad areas of market and public concern: (i) Protection of market participants and the public; (ii) efficiency, competitiveness and financial integrity of futures markets; (iii) price discovery; (iv) sound risk management practices; and (v) other public interest considerations. [1265]

1. Introduction

The terms “major swap participant” and “swap dealer” are defined in CEA sections 1a(33) and 1a(49), as added by the Dodd-Frank Act, to include any person that holds swap positions above a certain level (in the case of the term “major swap participant”) or that engages in certain activities (in the case of the term “swap dealer”), with certain exclusions and exceptions, all as discussed in parts II and IV of this Adopting Release. Section 712(d)(1) of the Dodd-Frank Act directs the CFTC and the SEC, in consultation with the Board, jointly to further define these and other terms. Also, CEA section 1a(49)(D) directs the CFTC to promulgate regulations to establish factors with respect to the making of the determination to apply the de minimis exception to the definition of the term “swap dealer.”

The provisions of the Dodd-Frank Act that direct the further definition of the terms “swap dealer” and “major swap participant” should be viewed in the context of Congress' consideration of the consequences that would arise from regulating persons and activities that were previously free from regulation. The Dodd-Frank Act is, in part, a response to a financial crisis in which unregulated swaps played a major role. [1266] It includes provisions to regulate swap dealers and major swap participants in order to address concerns about this previously unregulated market. In this context, the Dodd-Frank Act requires that rules should “further define” the terms “swap dealer” and “major swap participant” by establishing and providing guidance with respect to the criteria for determining if a person is covered by one of the statutory definitions and therefore should be subject to certain regulatory requirements under Title VII; the Dodd-Frank Act does not direct the Commissions to define those terms in a vacuum. So, even in the absence of these rules, Title VII would require the regulation of persons that act as swap dealers or hold positions causing them to be major swap participants. Consequently, a large part of the costs and benefits resulting from the regulation of swap dealers and major swap participants result from the Dodd-Frank Act itself and not from these definitional rules.

2. General Cost and Benefit Considerations

In considering the comments on the proposed rules and the various alternatives available for the final rules, the CFTC sought to promulgate final rules that will help swap market participants and the public to apply the statutory definitions of the terms “swap dealer” and “major swap participant” in an efficient, uniform and accurate manner. We believe that doing so will protect market participants and the public, promote the efficiency, competitiveness and financial integrity of the swap markets, facilitate price discovery, encourage sound risk management practices and advance the public interest in general. That is, by providing direction and guidance as to which factors are relevant in applying the statutory definitions, and how to apply those factors to particular situations in the swap markets, the CFTC believes the final rules will provide benefits by reducing the cost of determining whether a particular person is covered by the statutory definitions, helping to make similar determinations for persons that are similarly situated, and promoting application of the terms “swap dealer” and “major swap participant” in conformity with the statutory definitions.

The costs and benefits considered in this final rule fall in two categories: First, those an entity will experience in determining whether it is a “swap dealer” or “major swap participant” as further defined in this rulemaking; and second, those attributable to the fact that, as interpreted in this rule, a greater or fewer number of entities at the boundaries of the statutory definitions may be deemed within them.

With respect to the first category, and as discussed further in sections V.A.3.j. and V.A.4.b. below, the CFTC has endeavored to approximate the costs of making these determinations. At the same time, the CFTC believes that the careful consideration of, and detailed response in this Adopting Release to, comments regarding the application of the statutory definitions will provide useful, practical guidance, yielding a substantial if unquantifiable benefit to entities making such determinations.

The costs and benefits in the second category—those associated with the rules being more or less inclusive—were a primary concern of the CFTC and commenters throughout this rulemaking. Commenters stated that if the CFTC's final rules were to lead to interpretations of the statutory definitions that are over-inclusive, the result would be that entities would likely incur significant, unjustifiable costs attributable to various regulatory requirements intended for actual swap dealers and major swap participants. [1267] Other commenters were concerned that if the rules were to lead to under-inclusive interpretations, the benefits expected from Title VII would be dampened. [1268]

The CFTC does not dismiss these potential unintended results and we have responded to these comments in the policy determinations made above. [1269] We recognize that these definitional rules are “gating” rules, and that this gating function will affect whether entities at the boundaries of the statutory definitions incur costs attributable to the regulatory regime that Congress has prescribed and the CFTC has implemented through other substantive regulations. Correspondingly, these definitional rules will also affect the extent of benefits for the swap market and the public resulting from those regulations. It is important to also recognize, however, that as stated above, the regulation of persons acting as swap dealers or who hold positions causing them to be major swap participants is required by the Dodd-Frank Act. For entities that are not on the boundaries of the statutory definitions, but rather squarely within them or entirely outside of them, these rules will not affect the costs and benefits that result from their inclusion or exclusion. The latter group of costs and benefits are a consequence of the statutory definitions prescribed by Congress.

In this rulemaking, we considered that more inclusive rules and guidance would cause some entities at the boundaries of the definitions to be covered by one of the definitions and therefore incur both initial and recurring direct costs of complying with Dodd-Frank Act requirements, while less inclusive rules and guidance would have the opposite effect. [1270] Thus, as more or fewer entities are covered by the definitions, the amount of such direct compliance costs incurred by entities in the aggregate will vary. However, this variance in the aggregate compliance costs resulting from the CFTC's definitional guidance in this rulemaking must be distinguished from the compliance costs that any particular entity will incur stemming from the other rulemakings prescribing regulations applicable to swap dealers and major swap participants. Consideration of the specific costs and benefits attendant to various substantive regulations applicable to swap dealers and major swap participants is beyond the limited scope of this rulemaking.

Moreover, the variance in aggregate compliance costs resulting from this rulemaking will not track, on a “one for one” basis, the number of entities included in the definitions as the rules are more or less inclusive. This is because the initial and recurring compliance costs for any particular swap dealer or major swap participant will depend on the size, existing infrastructure, level of swap activity, practices and cost structure of the entity designated as such. [1271] Another reason that the aggregate costs resulting as more or fewer entities are included in the definitions will not precisely track the number of such entities is that indirect costs are likely to result as market participants seek to avoid the regulations attendant to swap dealer or major swap participant status by, among other things, reducing their swap activities. [1272] We do not expect that the extent of these indirect costs will be directly related to the number of entities included in the definitions.

The CFTC likewise acknowledges that more or less inclusive definitions may increase or decrease the systemic benefits expected from the composite regulation of swap dealers and major swap participants. These include improved transparency and market orderliness, as well as the reduction of excess leverage and systemic risk. The CFTC believes that less inclusive final rules could negatively impact these interests in several ways: Those who engage in swaps with entities that elude swap dealer or major swap participant status and the attendant regulations could be exposed to increased counterparty risk; customer protection and market orderliness benefits that the regulations are intended to provide could be muted or sacrificed, resulting in increased costs through reduced market integrity and efficiency; [1273] and entities that elude swap dealer or major swap participant status may gain an unwarranted competitive advantage over other market participants. [1274]

Generally, rules that capture more entities are likely to increase these benefits, while rules that capture fewer entities are likely to have the opposite effect, though there are several additional factors that also have a bearing on the presence and magnitude of increased or decreased benefits. These factors include the number and size of entities whose status changes under more or less inclusive rules, the number of swaps they engage in, their connectedness to other institutions and role in the financial system, and the types of financial instruments they would have utilized in the absence of swap dealer and major swap participant regulations.

At this time, it is also not possible to quantify the impact of these rules on the direct and indirect costs and benefits that result from changing the status of an entity that is on the boundaries of the Dodd-Frank Act's definitions of the terms “swap dealer” or “major swap participant.” The CFTC does not have adequate information about market participants' swap activities to determine which entities will change their activities in response to the definitions, which would be necessary in order to determine the significance of the impact on costs and benefits of including or excluding those entities from the regulations pertaining to swap dealers and major swap participants. Costs may not be estimated in an accurate or meaningful way for many reasons, including because all of the regulations pertaining to swap dealers and major swap participants have not yet been issued in their final form, and because the CFTC does not have adequate information about market participants' existing technology, infrastructure, use of swaps, or cost structure. [1275] Changes in the total benefits resulting from the definitional regulations are also difficult to quantify, since many of the benefits of the swap dealer and major swap participant regulations are indirect, rather than direct. As a consequence, the CFTC may recognize and describe the impact of these rules on the overall costs and benefits deriving from swap dealer and major swap participant regulations, but it is not possible to quantify them at this time.

The applicable provisions of the Dodd-Frank Act regarding the term “eligible contract participant” are somewhat different, in that the statute modifies a particular clause in the pre-existing statutory definition of the term and also provides general authority to further define the term. The final rules adopted in this regard provide guidance for the application of these provisions.

3. Comments on the Discussion of Costs and Benefits in the Proposing Release

Some commenters suggested that the discussion in the Proposing Release of the costs and benefits of the proposed rules further defining the terms “swap dealer, ” “major swap participant” and “eligible contract participant” was inaccurate or inadequate. [1276] For example, commenters suggested that in considering the final rules, the CFTC should consider empirical data regarding the costs and benefits flowing from the rules, [1277] opportunity costs associated with regulatory uncertainty, [1278] and alternatives that would impose fewer costs. [1279] One commenter suggested that the CFTC should issue a second analysis of the costs and benefits of the rules for public comment, [1280] while another commenter said that the consideration of cost and benefits should include the cumulative cost of interrelated regulatory burdens arising from all the rules proposed under the Dodd-Frank Act. [1281]

Another commenter said that the cost-benefit analyses in the Proposing Release may have understated the benefits of the proposed rules, because focusing on individual aspects of all the rules proposed under the Dodd-Frank Act prevents consideration of the full range of benefits that arise from the rules as a whole, in terms of providing greater financial stability, reducing systemic risk and avoiding the expense of assistance to financial institutions in the future. [1282] This commenter said the consideration of benefits of the proposed rules should include the mitigated risk of a financial crisis. [1283]

We have endeavored to address the commenters' concerns in this Adopting Release by undertaking careful consideration of various alternatives proposed by commenters as described in this section. With regard to the comments suggesting that we consider empirical data, the CFTC found that no comprehensive, publicly available empirical data related to the usage of swaps in all markets is available, and commenters provided very little empirical data to aid us in this rulemaking.

4. Costs and Benefits of the Rules Further Defining “Swap Dealer”

The Proposing Release proposed certain factors that could be relevant to market participants when determining whether they are covered by the statutory definition of the term “swap dealer.” The CFTC received comments in response to numerous issues and considered a variety of alternatives in light of those comments, weighing the costs and benefits of each. In particular, we considered alternatives with respect to the activities indicative of holding oneself out as, or being commonly known as, a dealer in swaps, making a market in swaps, entering into swaps as a “regular business,” the exclusion available to IDIs for swaps offered in connection with the origination of loans, inter-affiliate swaps, swaps hedging physical positions, limited dealer status, and the possibility of providing particularized treatment under the definition for various types of entities.

As noted above, in considering these alternatives the CFTC's primary objective was to promulgate a rule under which market participants could efficiently and accurately determine whether they are engaged in any of the activities that are included in the statutory definition of swap dealer, and whether they are covered by any of the exclusions in the statutory definition. The scope of our consideration of these alternatives included the five factors specified in section 15(a) of the CEA. That is, we considered how the promulgation of final rules that would promote application of the definition of the term “swap dealer” in a manner that is consistent with the statutory definition would protect market participants and the public, promote the efficiency, competitiveness and financial integrity of the markets, [1284] facilitate price discovery, encourage sound risk management practices and serve the public interest. Rather than describing in a separate section how we applied the elements of section 15(a) in the final rule further defining the term “swap dealer,” the discussion below highlights the application of those elements where appropriate.

a. Indicia of Holding Oneself Out as a Dealer in Swaps or Being Commonly Known in the Trade as a Dealer in Swaps

As discussed above, the Proposing Release set forth activities that could indicate that a person is holding oneself out as a dealer or is commonly known in the trade as a dealer in swaps. [1285] Commenters on this point said that persons who are not swap dealers also engage in some of the activities identified in the proposed rule. In other words, these commenters asserted that these activities are not accurate indicators of swap dealer status. [1286]

Commenters were concerned that if the rule included, as bright-line tests of swap dealer status, the proposed indicators of holding oneself out as, or being commonly known as, a swap dealer, then the rule would lead to an interpretation of the statutory definition that would be more inclusive. This, in turn, would lead to the costs of a more inclusive rule, and possibly the costs of entities abstaining from swap activities to avoid being covered by the definition, as discussed above. [1287]

While we are cognizant that providing no guidance about how to apply the statutory provision stating that the term “swap dealer” includes any person who holds itself out as a dealer in swaps or is commonly known in the trade as a dealer or market maker in swaps would deprive market participants of interpretive guidance—thus increasing the direct and indirect costs to apply the rule—we considered the commenters' concern that use of the proposed characteristics as bright-line indicators of swap dealer status could potentially result in significant costs. Therefore, to mitigate the costs of applying the rule and the costs that would result if the rule were more inclusive, the Adopting Release clarifies that the identified activities are not per se conclusive, and could be countered by other facts and circumstances indicating that an entity is not a swap dealer. The CFTC believes that providing guidance about the factors that are correlated with holding oneself out as or being commonly known as a swap dealer—even if not perfectly so—mitigates the risk that the rule would include entities that are not actually covered by the statutory definition and provides benefits in reducing the costs of application of the rule.

b. Making a Market in Swaps

Commenters on this point provided several perspectives on what does and does not constitute market making. [1288] With those comments in view, we considered a number of characteristics for potential inclusion in the rule, and evaluated potential costs and benefits of each before determining that making a market in swaps is best described as “routinely standing ready to enter into swaps at the request or demand of a counterparty.” We also further described various activities that constitute routinely standing ready, such as routinely quoting bid or offer prices for swaps, routinely responding to requests made directly by potential counterparties for bid or offer prices, etc. The alternative options we considered are discussed below in light of the five broad areas specified in section 15(a) of the CEA.

Offer swaps on both sides of the market. The proposed rule stated our view that an entity may be a market maker in swaps even if the entity does not enter into swaps on both sides of the market. Several commenters suggested the rule should require that an entity enter into swaps on both sides of the market as a prerequisite to market maker status. [1289] We have considered these comments and concluded that an entity could be a market maker by offering swaps on one side of the market, while entering into transactions on the other side of the market using other financial instruments.

Accordingly, using presence on both sides of the market as a determinative factor in applying the definition of the term “swap dealer” could cause the final rule to be under-inclusive by excluding entities that function as market makers by entering into swaps on one side of the market. In addition, some entities may limit their swap dealing activities to one side of the market in an attempt to avoid being covered by the definition, again leading to the rule being under-inclusive.

Excluding cleared swaps from consideration. Some commenters said cleared swaps should not be considered in determining whether an entity is a swap dealer. [1290] Moreover, they suggested that dealers operating through clearinghouses might choose to exit the market if required to register as swap dealers, which would reduce liquidity. [1291]

It is possible that some entities whose swap dealing activities are limited to cleared swaps will abstain from those activities in order to avoid being covered by the definition, leading to costs associated with entities abstaining from the market, as described above. Other such entities may continue their swap dealing activities and incur the initial and ongoing costs of compliance with swap dealer regulations. Benefits are linked to these compliance costs, however. For example, the swap dealer business conduct requirements are expected to provide benefits in terms of protecting market participants and the public. In any case, we note that the statutory definition of the term “swap dealer” does not include any factor considering whether the swaps that an entity enters into are cleared as opposed to not cleared. Therefore, the costs raised by commenters resulting from the absence of an exclusion of cleared swaps are costs that result from the statutory definition and not the final rule.

c. Regularly Entering Into Swaps With Counterparties as an Ordinary Course of Business

The final rule incorporates the statutory provisions that the term swap dealer includes a person that “regularly enters into swaps with counterparties as an ordinary course of business for its own account” and “does 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.” The CFTC believes that the determinative issue in interpreting these provisions is whether an entity's activity of entering into swaps is part of its usual and normal course of business and is identifiable as a swap dealing business, as discussed above. [1292] This Adopting Release also describes certain activities that constitute both entering into swaps “as an ordinary course of business” and “as a part of a regular business.” [1293]

The CFTC believes that dealers frequently engage in the activities described in this Adopting Release, while non-dealers do not. [1294] As a consequence, such activities are useful indicators of swap dealing activity and it is appropriate to incorporate them in the guidance interpreting the final rule in order to properly apply the statutory definition.

d. The Dealer-Trader Distinction

The Adopting Release incorporates the dealer-trader distinction as a consideration when identifying swap dealers. While not dispositive, the CFTC anticipates that the dealer-trader distinction will be useful as a consideration, particularly in light of the degree to which it overlaps with many of the other characteristics identified in the Adopting Release that are indicative of dealing activity. The dealer-trader distinction is likely to be familiar to some market participants that must determine whether they are swap dealers, and to the extent that this is true, the CFTC believes that its incorporation as a factor in the swap dealer analysis will help to reduce uncertainty for those entities, thereby reducing their costs of determining whether they are dealers. [1295] By incorporating the dealer-trader distinction as one consideration within a broader facts and circumstances approach, the CFTC has minimized the costs of under inclusion that could arise if the distinction were used as a bright line test to exempt entities that would otherwise be subject to regulation as swap dealers. [1296]

e. Limited Designation as a Swap Dealer

The Proposing Release provided that “a person who is a swap dealer shall be deemed to be a swap dealer with respect to each swap it enters into” but explained that an entity could apply for limited designation. Several commenters suggested that the CFTC should allow for the possibility of “presumptive limited designation” as a swap dealer in order to reduce costs. [1297] We have decided, however, not to provide for a presumptive limited designation in the final rule. While a presumptive limited designation would, for the entities that seek it, mitigate the costs of applying for limited designation and any costs related to uncertainty about whether limited designation will be granted, [1298] it could also lead to costs arising from the rule being less inclusive. Persons engaged in a broad range of activities that are all covered by the definition of the term “swap dealer” would have a significant incentive to improperly claim eligibility for a presumptive limited designation. This would hinder the application of swap dealer regulations to all of their swap dealing activities and thereby increase costs in terms of lesser protection of market participants and the public, as well as impairment of sound risk management practices.

Commenters suggested that to reduce the costs of determining whether a particular person is eligible for a limited designation as a swap dealer, the CFTC should set out certain criteria that would be relevant to that determination, such as the degree of complexity of an entity's swap activities, what percentage of an entity's total swap activities are dealing activities, the relationship between the entity and its swap counterparties, and how difficult it would be to distinguish between its “designated” and “non-designated” swaps. [1299]

Rather than setting forth specific factors to be considered with respect to limited designation as a swap dealer, this Adopting Release takes a facts and circumstances approach, stating that all relevant factors will be considered in the determination. This Adopting Release also states that an important factor in determining whether a swap dealer qualifies for a limited designation is whether the swap dealer can demonstrate that the internal structure to which the limited designation applies (e.g., a division or business unit) complies with the swap dealer requirements. If such a structure is not pre-existing, the swap dealer will incur costs in creating a structure for its swap dealing activity in a manner that would qualify for limited designation. These costs depend on the circumstances of that swap dealer and cannot be quantified at this time; however, such costs are likely to be significant for at least some swap dealers. On the other hand, swap dealers who do qualify for the limited designation will benefit from reduced ongoing compliance costs since some swap dealer requirements are expected to apply to only those activities encompassed by the limited designation. [1300] This flexible approach will allow entities to organize themselves in a manner that allows them to maximize the value of limited designation, so long as they are able to demonstrate that they will comply with swap dealer requirements. In settling on this flexible approach, we considered how the use of a limited designation would allow entities to minimize the effect of swap dealer registration on their swap activities, which fosters efficiency while also promoting sound risk management practices through swap dealer regulation.

The facts and circumstances approach to limited designation will likely lead to some costs arising from uncertainty among market participants about whether steps they have taken or may take will permit them to qualify for a limited designation. However, we believe that market participants may mitigate such uncertainty costs by contacting staff to discuss changes under consideration, or by applying for limited designation on the basis of planned changes (rather than making the changes and then submitting the application).

f. De Minimis Exception

The Dodd-Frank Act requires that the CFTC exempt from designation as a swap dealer any entity “that engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of customers,” and that the CFTC “promulgate regulations to establish factors with respect to the making of this determination to exempt.” [1301]

The proposed rule set out certain quantitative standards for identifying those entities whose swap activities were sufficiently small that applying swap dealer regulations to them would not be warranted. [1302] Commenters raised several points regarding the potential costs and benefits of the proposed approach. We considered these points, addressed below, in preparing the final rule, which provides that an entity qualifies for the de minimis exception if the notional amount of its swap positions or security-based swap positions over the prior 12 months arising from its dealing activity is $3 billion or less, and the notional amount of such positions with “special entities” is $25 million or less. However, during a phase-in period following the effective date of the final rules, an entity will not be required to register as a swap dealer if the notional amount of the swap positions it enters into over the prior 12 months arising from its dealing activities is $8 billion or less. [1303]

In determining the level of the notional amount thresholds for the de minimis exception, we considered comments stating that if the thresholds were set inappropriately low, persons engaged in a smaller quantity of swap dealing would face a choice between reducing their swap dealing activities to a level below the thresholds or registering as a swap dealer and incurring the costs of compliance with swap dealer regulation. [1304] It follows from these comments that these entities would incur costs in making a decision about the extent to which they should engage in swap dealing, although none of the commenters specifically quantified the costs of making that decision. Commenters also expressed a concern that if many entities chose to reduce or cease their swap dealing activities in response to the de minimis thresholds, the availability of swaps may be reduced, particularly to the smaller swap users that typically engage in swaps with such entities, which could lead to costs for those smaller swap users. [1305] Some commenters said that the CFTC should justify the final thresholds for the de minimis exception with an economic analysis; however, these commenters did not propose specific analyses the CFTC should perform or provide specific information that should be included in the analysis. [1306]

The CFTC evaluated data regarding index CDS that was provided by the SEC, and made that analysis available to the public. [1307] The data showed that 80.8% of all participants in the index CDS market entered into index CDS with an aggregate notional amount of less than $3 billion during 2011, and 88.7% of such market participants entered into index CDS with an aggregate notional amount of less than $8 billion during the same period of time. However, the 19.2% and 11.3% of market participants above those respective thresholds, accounted for 98.9% and 97.8% of the total notional amount of index CDS entered into during that time, which suggests that a relatively small number of entities are responsible for a large majority of activity in the index CDS market. The data also showed that 91.7% of all entities with 3 or more counterparties that are not recognized by ISDA as dealers entered into index CDS with an aggregate notional amount of $9 billion or more during 2011, suggesting that a large majority of dealers in index CDS likely enter into index CDS with an aggregate notional amount of $9 billion or more per year.

These observations, and any conclusions derived from them, however, must be qualified by limitations of the data, including: (i) Although we expect that the data covers a very large part of the index CDS market, we cannot verify what percentage of all index CDS are represented in the data; (ii) the data is not filtered to reflect activity that would constitute swap dealing under the Dodd-Frank Act, so it is not possible to use the data to draw conclusions regarding any specific entity's status as a swap dealer and (iii) the data does not cover other classes of swaps that are relevant to the de minimis threshold for swap dealers, such as interest rate swaps, equity swaps, foreign exchange swaps or other commodity swaps. [1308] In light of these limitations, any conclusions drawn from the index CDS data must be regarded as provisional.

We note that no matter the level at which the de minimis thresholds are set, there will always be some entities engaged in a quantity of swap dealing at or above the threshold level that will face the choice described by the commenters. As noted above, we considered the costs and benefits of dealer regulation in determining the notional amount standards in the final rule. [1309] Among the costs we considered were those that would result if entities reduce or cease their swap dealing activities in response to the de minimis threshold and swaps become less available in smaller or niche markets. We considered that this could impact the competitiveness of those markets and undermine the ability of market participants to practice sound, cost-effective risk management. [1310] In principle, a higher threshold would promote a larger pool of swap-dealing entities (since entities with swap dealing activity below the threshold need not incur costs to comply with swap dealer regulations), meaning more potential counterparties available to swap users. On the other hand, a greater quantity of swap dealing would be undertaken without the customer protection, market orderliness and market transparency benefits of dealer regulation. This, in turn would impair the protection of market participants and the public, and undermine sound risk management practices, as described above. [1311] We considered these factors in determining the level of the notional amount standard in the final rule.

Some commenters advocated use of alternative measures (such as an entity's current uncollateralized exposure from swaps, or the number or frequency of swaps) as the de minimis gauge. [1312] Some commenters suggested that various types of entities should be subject to different de minimis thresholds, [1313] or that the rule should vary the de minimis threshold by type of swap. [1314] Some commenters suggested that the de minimis exception should take into account the purpose of an entity's swap dealing activities or the entity's general characteristics. [1315]

The CFTC believes that these proposed alternatives are unlikely to better promote the efficiency, competitiveness and financial integrity of the markets, or yield other benefits to a greater extent than the approach adopted in the final rule. [1316] On the other hand, requiring market participants to consider more variables in evaluating application of the de minimis exception would likely increase their costs to make this determination. In light of these considerations, we concluded that to establish a single notional threshold for all of an entity's swap dealing would best protect the markets and the public, foster efficiency and competitiveness and serve the public interest.

We believe that using a de minimis threshold based on current uncollateralized exposure would lead to costs of calculation, which are discussed below in connection with the definition of major swap participant. Also, while current uncollateralized exposure may be a useful measure of the risk arising from a swap position, it fails to address the significance of an entity's swap dealing activity in terms of customer protection and market orderliness, which are significant elements in the determination of whether an entity is engaged in a de minimis quantity of swap dealing. [1317]

In response to commenters' suggestions, we considered the feasibility of assessing the breakeven point at which a potential swap dealer would earn enough profit from its swap dealing to support the costs to comply with swap dealer regulation. [1318] However, this assessment would require access to non-public, proprietary data regarding the gross margins associated with the swap dealing activity of a wide variety of market participants. Such data is not available to the CFTC.

One commenter suggested that the de minimis threshold for swaps related to a particular physical commodity should increase if the general price of the commodity increases, so that a constant quantity of the commodity could be hedged through a particular swap dealing entity without that entity exceeding the threshold. [1319] However, this approach, which eschews reliance on the dollar value of swaps, would raise the complex question of when the level of dealing in swaps relating to the physical quantity of various commodities becomes more than de minimis. We do not believe that this approach would provide sufficient additional benefits beyond those resulting from the final rule to justify the additional costs of application.

Commenters also suggested that, in order to simplify application of the de minimis exception and thereby reduce costs, the final rule should include an overall threshold that considers an entity's swaps and its security-based swaps. [1320] However, the statute includes two different de minimis exceptions regarding the quantity of an entity's swap dealing and its security-based swap dealing. Therefore, the suggested approach would be contrary to the statute.

The final rule provides for a lower de minimis gross notional threshold (i.e.,$25 million over the course of twelve months) for swaps in which the counterparty is a “special entity,” as that term is defined in CEA section 4s(h)(2)(C) and CFTC Regulation § 23.401(c)). While it is possible that, for the reasons noted above, this lower threshold could reduce the number of potential providers of swaps to special entities, which may constrain the ability of special entities to practice sound risk management strategies in a cost-effective manner, we note that the Dodd-Frank Act provides special entities with additional protections from market practices that could increase the risks they face in using swaps. [1321] We believe the threshold in the final rule reflects an appropriate consideration of these potential costs and the benefits that result in terms of serving the public interest.

Several commenters responded to the proposed de minimis thresholds limiting the number of an entity's counterparties and swaps, suggesting that the factors would not be useful in identifying entities engaged in a de minimis quantity of swap dealing. [1322] The final rule omits these factors. We believe that, in general, entities which will restrict their activities so as to remain under the de minimis notional amount threshold are likely to be those entities that are most willing to provide swaps with lower notional values. Counting an entity's number of counterparties or swaps as de minimis factors could inappropriately discourage entities from providing swaps in smaller notional amounts. This, in turn, would likely make it more difficult for persons seeking small notional amount swaps to find dealers willing to provide them, which may increase their costs of hedging and discourage sound risk management practices.

g. Exclusion of Swaps Entered Into by IDIs in Connection With the Origination of Loans

The statutory definition of the term “swap dealer” excludes an IDI “to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.” [1323] The proposed rule would implement this statutory exclusion by providing that an IDI's swaps with a customer in connection with originating a loan to that customer are disregarded in determining if the IDI is a swap dealer. To prevent evasion, the proposed rule further provided that the statutory exclusion does not apply where the purpose of the swap is not linked to the financial terms of the loan, the IDI enters into a “sham” loan, or the purported “loan” is actually a synthetic loan such as a loan credit default swap or loan total return swap.

Commenters on the costs and benefits of the proposed approach focused on the benefits of a flexible application of the exclusion, which they asserted would promote the offering of swaps by IDIs in connection with loans and thereby more closely tailor the risks of a loan to the borrower's and the lender's needs, and promote the risk-mitigating effects of swaps. [1324] In terms of costs, commenters were concerned that a narrow application of the loan origination exclusion would cause IDIs to seek to avoid being covered by the definition of the term “swap dealer” by limiting their offering of swaps in connection with the origination of loans. Commenters said that the IDIs' limitation of their swap offerings could lead borrowers to take steps with negative ramifications, such as reduced usage of swaps for risk mitigation (which could lead to costs from an increased risk of default by the borrower), shifting from the lending institution to another institution for the swap (which could lead to inefficiency costs since two different institutions would be involved), or shifting to another institution for both the loan and the swap (which could increase risk by increasing concentration in the markets for loans and swaps). [1325] To mitigate these costs, commenters suggested that the loan origination exclusion should be construed broadly, particularly with respect to the range of loans covered, [1326] the type of swaps covered, [1327] the required timing for entering into a swap relative the corresponding loan's origination, [1328] and which financial institutions could be eligible for this exclusion. [1329]

The final rule limits the loan origination exclusion to swaps with terms that are directly related to the financial terms of the associated loan, or are required by loan underwriting criteria to to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower's business. We believe that extending the loan origination exclusion further, to encompass a broader range of swaps connected to a borrower's other business activities would expand the exclusion beyond its statutory limits. This would lead to the costs associated with the rule becoming less inclusive, such as decreased protection of market participants and the public, as well as impaired risk management practices and market efficiency, as described above.

This Adopting Release also includes guidance that the term “loan” should be construed for this purpose in accordance with the common law definition of the term, in order to efficiently allow all interested parties to determine which transactions and instruments are eligible to be a basis for the exclusion. The CFTC believes that a detailed definition of the term “loan” covering all of the potential variations in how loans may be structured would be both costly to apply (because of the level of analysis required to determine if a particular instrument qualifies as a loan) and unnecessary (because a common law definition of the term “loan” has already been established).

We believe that extending the loan origination exclusion to cover any swap entered into by an IDI and a borrower at any point during the life of the loan would be contrary to the statutory terms of the exclusion, which focuses specifically on swaps entered into in connection with the “origination” of loans, and could lead to the costs of the rule being less inclusive described above. Rather, since a primary element of a loan is the transfer of money from the lender to the borrower, the final rule provides that the loan origination exclusion can cover an otherwise eligible swap if the swap is entered into during a specified period around either the execution of the loan agreement or any draw of principal under the loan. We believe that this aspect of the final rule accurately reflects the statutory terms of the exclusion and will serve the public interest by being neither over-inclusive nor under-inclusive.

Commenters generally agreed with the statement in the Proposing Release that the exclusion should be available to IDIs in a loan syndicate, purchasers of a loan, assignees of a loan, and participants in a loan. [1330] We believe that allowing the loan origination exclusion to extend to IDIs that participate in loans accurately reflects the statutory terms of the exclusion, so long as the IDIs' participations are meaningful. Therefore, the rule includes a minimum participation requirement in order to avoid inappropriate exploitation of the exclusion—i.e., IDIs participating minimally in a loan syndication to gain eligibility for the exclusion — which could lead to costs of under-inclusion. The final rule allows the exclusion to be applied to a swap (which is otherwise covered by the exclusion) even if the notional amount of the swap is different from the amount of the loan tranche assigned to the IDI, so long as the IDI meets the minimum participation requirements in the loan. This provision is expected to facilitate minimization of the number of swaps borrowers enter into, and the number of counterparties they face with respect to those swaps, when entering swaps in connection with loans, thereby reducing the operational costs and risks born by borrowers.

h. Inter-Affiliate Swaps

The Proposing Release stated that the dealer analysis should consider the economic reality of swaps between affiliates, and preliminarily concluded that swaps “between persons under common control may not involve the interaction with unaffiliated persons that we believe is a hallmark of the elements of the definitions that refer to holding oneself out as a dealer or being commonly known as a dealer.” Commenters generally agreed with the proposed approach. [1331] Some commenters expressed the view that the proposed approach would facilitate the use by affiliated corporate groups of centralized market-facing conduits, which would promote efficient risk management. [1332]

The final rule interprets the dealer definition not to encompass a person's activities with respect to swaps between legal entities that are under common majority ownership. The final rule also provides that the swap dealer definition does not encompass the activities of a cooperative with respect to swaps between the cooperative and its members. We believe that such swaps generally serve to allocate or transfer risks within an affiliated group, rather than to move those risks out of the group to an unaffiliated third party, and therefore to include such swaps in the determination of whether an entity is a swap dealer would not be consistent with the statutory definition, nor would it serve the public interest or promote the protection of markets or the public. We also agree with commenters that the use of conduit structures to enter into swaps on behalf of commonly controlled entities has the potential to promote sound risk management practices and the efficiency of the swap markets. Therefore, including these swaps in the determination of whether a person is covered by the definition of “swap dealer” is not likely to provide significant benefits, but to include entities in the definition by virtue of these swaps would lead to the costs of the rule being overinclusive, as described above.

i. Exclusions of Swaps Entered Into for Hedging Physical Positions

Several commenters said that swaps used to hedge risks should not be considered in determining whether a person is a swap dealer. While the statutory definition of the term “swap dealer” does not specifically address hedging activity, the Commissions believe that in certain situations, entering into a swap for the purpose of hedging a physical position is not indicative of, and is not, swap dealing. An interim final rule provides that the determination of whether a person is a swap dealer will not consider a swap that the person enters into for the purpose of offsetting or mitigating certain price risks as defined in the rule, if the swap meets conditions specified in the rule.

When a person enters into a swap for the purpose of hedging the person's own risks in specified circumstances, an element of the swap dealer definition—the accommodation of the counterparty's needs or demands—is absent. Therefore, consistent with our overall interpretive approach to the definition, the activity of entering into such swaps (in the particular circumstances defined in the rule) does not constitute swap dealing. Providing an exclusion of such swaps from the swap dealer analysis reduces costs that persons using such swaps would incur in determining if they are swap dealers.

j. Exclusions of Certain Swaps Entered Into by Floor Traders

The CFTC believes that it would be inappropriate to require persons who are registered with the CFTC as floor traders to include in the swap dealer analysis swaps that they enter into, using only proprietary funds, on or subject to the rules of a DCM or SEF and submit for clearing to a DCO, and that meet certain other conditions specified in the rule. The CFTC believes that a requirement that these persons register as swap dealers (if the swap dealer registration requirement were to apply) could lead to duplicative regulation, since they are already registered as floor traders.

Providing an exclusion of such swaps from the swap dealer analysis reduces costs that persons using such swaps would incur if such swap activity were to require them to register as swap dealers. Since the swaps are entered into on an exchange, by a person who is registered with the CFTC and cleared, we expect that the potential impact on the transparency, market orderliness and other goals of dealer registration from excluding these swaps from the dealer analysis would be minimal. Importantly, the rule requires that the person comply with the record keeping and risk management requirements of CFTC Regulation §§ 23.201, 23.202, 23.203, and 23.600 with respect to each such swap as if the person. were a swap dealer. The requirement to comply with these important provisions reduces the potential for negative consequences from this rule.

k. Exclusions for Particular Types of Entities

Several commenters said the CFTC should interpret the statutory definition of “swap dealer” to include per se exemptions from the definition for certain types of persons or persons who engage in certain activities. [1333] These commenters argued, in general, that there would be little or no benefit from construing the statute as covering these persons or activities because they did not contribute to the causes of the recent financial crisis or they do not pose systemic risk. [1334] These commenters also asserted that to interpret the statutory definition to cover these types of persons or activities would lead to the costs of the rule being more inclusive, as noted above. [1335]

As stated previously, we note that the statutory definition of the term “swap dealer” applies to “any person” who engages in the activities described in the statute and who does not fall within the specific exceptions and exclusions in the statute. Therefore, the costs of applying the statutory definition to certain types of persons identified by the commenters arise from the provisions of the statute and not from the CFTC's rulemaking. In addition, to provide the requested per se exemptions from the statutory definition could also introduce the costs of the rule being less inclusive discussed above, such as decreased protection of market participants and the public, as well as impaired risk management practices and market efficiency.

Regarding the argument that there is no or little economic benefit from interpreting the statutory definition to cover persons whose failure would not create systemic risk, the commenters making this point did not provide evidence or analysis to indicate whether there would be systemic risk concerns if they were to fail. While some of these commenters asserted that their swap activities are not comparable to the activities of the financial institutions that are generally considered to have had a significant role in the recent crisis, and some asserted that persons eligible for the claimed exemptions did not play a role in the crisis, even if these assertions are taken as true they are not determinative of whether persons of this type could in fact be a source of systemic risk. We emphasize that the relevant question in this regard would not be whether the failure of any one person within the class covered by a suggested exemption would be the source of systemic risk, but rather whether a failure of several or many such persons would impact the efficiency, competitiveness and financial integrity of the markets, impair sound risk management practices or otherwise affect the protection of markets and the public. [1336] To be clear, we do not believe and we are not asserting that any of the types of persons discussed by the commenters in this regard necessarily could be the source of systemic risk concerns, but rather we point out that the comments in this regard were general assertions rather than a presentation of specific evidence or analysis to support the claimed exemptions from the statutory definition. Thus, even if the statute allowed for such exemptions, which we do not believe it does, none of the commenters provided substantial support for their assertions. Also, as noted above we believe that the dealer definitions should be construed in the light of several benefits of dealer regulation (including protection of the markets and the public, encouraging the efficiency, competitiveness and financial integrity of the swap markets, and the overall public interest) and not just in terms of mitigating potential systemic risk.

In any case, we believe that the final rule and the guidance in the Adopting Release provide clarifications that in many respects mitigate the costs that were raised by some of the commenters seeking per se exemptions from the definition.

l. Other Comments on the Rule Further Defining the Term “Swap Dealer”

Commenters cited other potential costs that could arise from the proposed approach to interpreting the statutory definition of the term “swap dealer,” suggesting that the proposed approach was not sufficiently clear, may result in multiple interpretations, and risks covering entities that would not actually be covered by the statutory definition, if it were correctly interpreted. [1337] Other commenters suggested that there could be high costs from application of the swap dealer regulations due to erroneous interpretation of the statutory definition of the term “swap dealer,” including high costs of regulatory uncertainty, [1338] and therefore it is particularly important that the final rule provide guidance on the application of the statutory definition. [1339] For example, these commenters said that if the final rule does not adequately clarify application of the statutory definition, market participants may incur unnecessary costs to avoid being covered by the definition of “swap dealer,” including by avoiding swap activities that are associated with areas of uncertainty under the rule. [1340]

Some commenters said that the proposed rule captures too broad a range of entities in its further definition of the term “swap dealer,” [1341] and that the asserted over-inclusiveness of the proposed rule could lead to direct costs for covered entities as well as indirect costs for covered entities, other swap market participants, and the public. [1342] For example, the commenters assert that as entities change their swap activities in reaction to the rule, the objectives they previously achieved through swaps may either be compromised, accomplished through less suitable means, or both. [1343] As another example, the commenters assert that changes in swap activities may reduce the choice of counterparties available to market participants, which may lead to unfavorable financial terms for swaps and imperfect matches between risks and swaps, which could in turn lead to reduced usage of swaps and lower liquidity in the swap markets, resulting ultimately in increased costs of risk mitigation in general. [1344]

The commenters did not quantify the extent of these costs that may arise when entities change their swap activities in reaction to the rule further defining the term “swap dealer.”

We believe that by addressing the concerns regarding the costs and benefits of specific aspects of the rule, discussed above in section V.C.5., the final rule will also mitigate the indirect costs that may arise from the rule. While it is impossible to completely eliminate the costs that entities will incur in interpreting the rule and applying it to their particular swap activities, we believe the final rule mitigates these costs by providing detailed guidance. Also, these costs may decrease over time as precedents are established to provide further guidance on the application of the statutory definition.

For example, the final rule and the guidance in this Adopting Release mitigate the costs of uncertainty in application of the statutory definition by providing more detail about the interpretation of the statute's inclusion of any person who “makes a market in swaps” and the statute's exclusion of a person that enters into swaps, “but not as a part of a regular business.” The guidance describes activities that are indicative of making a market in swaps and of entering into swaps as a part of a regular business. The final rule also provides details regarding the scope of the statutory exclusion of swaps in connection with the origination of loans and the de minimis exception. Also, the final rule provides that swaps between majority-owned affiliates, swaps entered into by a cooperative with its members, swaps entered into for hedging physical positions as defined in the rule, and certain swaps entered into by floor traders, are excluded from the swap dealer determination. These provisions will reduce the costs that market participants incur in determining whether they are covered by the statutory definition of the term “swap dealer.”

While it is possible that some entities could choose to cease or reduce their swap dealing activities to avoid the costs of compliance with swap dealer regulations, which could impair the efficiency and competitiveness of the swap markets, there are also likely to be significant benefits derived from swap dealer regulation, including reduced counterparty risk, better protection of the markets and the public, and more assured financial integrity of the markets and improved market transparency. Moreover, whether such reductions in activity will lead to reduced liquidity in the swap markets, as some commenters assert, is not certain. For example, if such reductions in swap activity occur, new swap dealers may organize themselves or existing swap dealers may expand to accommodate the demand for swaps, although the time that would be required for this to occur and the extent to which it would occur are uncertain.

In addition, indirect costs could arise from the rule being less inclusive. For example, if the rule considered factors that are not relevant to whether an entity is actually covered by the definition, such as by providing that only entities that make a two-sided market in swaps are makers of markets in swaps, then it is possible that entities could change their behavior in response to that aspect of the rule. For example, entities that previously made a two-sided market in swaps may decide to make only a one-sided market in swaps, potentially leading to the types of costs that commenters said would arise if entities reduce their swap activities.

Last, several commenters raised questions and offered suggestions about the timeline for implementation of swap dealer requirements [1345] and the sequencing of the CFTC's rulemaking. [1346] While we understand that appropriate timing of rulemaking and the implementation of the requirements applicable to swap dealers will play a significant role in mitigating inappropriate or avoidable costs flowing from those requirements, this rulemaking is limited to the interpretation of the statutory definition of the term “swap dealer,” and so these comments are beyond the scope of this rulemaking.

In sum, we are cognizant that both direct and indirect costs would arise if the rule further defining the term “swap dealer” did not appropriately reflect the statutory definition of the term. Such costs, which would arise as the rule is either more or less inclusive, are detailed above. The Adopting Release provides benefits by interpreting the term “swap dealer” in a manner that is as close as possible to the statutory definition of the term, thereby mitigating the potential costs of both over-inclusiveness and under-inclusiveness.

m. Costs of Applying the Rules Further Defining the Term “Swap Dealer”

In order to apply the rules further defining the term “swap dealer” and determine whether or not it is covered by the definition, an entity will incur direct costs in the form of personnel hours devoted to analyzing the entity's activities with respect to swaps and determining whether the entity is covered by the definition. These costs will depend on the nature of the entity's swap activities in the relevant situation. For some entities, it will be relatively clear that they are covered by the definition and they will incur relatively few costs in confirming that. It is expected that for many entities it will be relatively clear that they are not covered by the definition and they will incur little or no cost in confirming that determination. However, for some entities, especially those that enter into swaps in a variety of different ways and circumstances, the determination will be more complex and will require that personnel with financial and legal expertise review the circumstances of the entity's swap activities to make the determination of whether the entity is covered by the definition.

It is important to recognize that this would be the case in the absence of any rule further defining the term “swap dealer,” or regardless of the terms of the rule, because entities would have to interpret the statutory definition to determine whether they are covered. Thus, at a minimum, a significant portion of the costs discussed below is attributable to the inclusion in the Dodd-Frank Act of a definition of the term “swap dealer” and not from any aspect of the final rules further defining that term. Indeed, the final rule provides benefits by minimizing these costs by providing guidance about the application of the statutory definitions in various situations.

The amount of time and resources that must be expended by an entity in order to determine whether it qualifies as a dealer will vary considerably depending on the complexity of the entity's operations. In addition, the direct costs will vary depending on the determinations the entity must make—reviewing whether or not it is covered by the definition of the term “swap dealer,” whether it qualifies for the de minimis exception, or whether it seeks to obtain a limited purpose registration as a swap dealer. Depending on an entity's situation, it may incur some or all of these costs. We did not receive any comments quantifying the costs that an entity may incur in applying any aspect of the definition of “swap dealer,” nor are we aware of any studies or surveys regarding this particular issue. Therefore, the CFTC staff has estimated the amount of time that entities may require to apply the definition in various situations. These estimations are for informational purposes and require the CFTC to consider the aforementioned highly uncertain criteria.

Regarding the determination of whether an entity is covered by the definition of the term “swap dealer,” an entity with a relatively low degree of complexity in its organizational structure (i.e., one legal entity) and in its swap activities (i.e., little variation in the types of swaps they use and the purposes for which they use them) might expect the direct cost of such a determination to be approximately $13,000. [1347] We estimate that approximately 250 entities of this type would be engaged in swap activities that create sufficient uncertainty regarding the application of the definition that they would have to incur these costs. An entity with a moderate degree of complexity in its organizational structure (i.e., a few legal entities) and its swap activities (i.e., some variation in the types of swaps they use and the purposes for which they use them) might expect the cost of such a determination to be approximately $54,000. [1348] We estimate that approximately 150 entities of this type would be sufficiently uncertain regarding the application of the definition that they would have to incur these costs. An entity with a high degree of complexity in its organizational structure (i.e., multiple affiliates in the corporate group) and its swap activities (i.e., using diverse types of swaps for various purposes) could spend approximately $170,000 when making a determination as to whether it is covered by the definition of swap dealer. [1349] We estimate that approximately 50 entities of this type would be sufficiently uncertain regarding the application of the definition that they would have to incur these costs. Thus, the total direct cost for all entities to determine the coverage of the definition of the term “swap dealer” would be approximately $20,000,000.

As noted above, we estimate that approximately 450 entities (i.e., 250 with relatively low complexity, 150 with moderate complexity and 50 with high complexity) would be sufficiently uncertain about the application of the definition of the term “swap dealer” that they would incur costs in applying the definition. This estimate includes IDIs that apply the loan origination exclusion. It is important to emphasize that since there is no definitive publicly available information about how many entities are engaged in swap activities and how they use swaps in particular situations, it is impossible to be sure how many entities may be uncertain about whether the definition covers them to the point that they would incur such costs. However, we believe that the number of such entities may be estimated based on certain assumptions as discussed below.

In meetings with commenters since publication of the Proposing Release, the CFTC has discussed extensively the universe of potential entities that may be covered by the definition of the term “swap dealer” and gathered information on the swap market and its participants. In its FY 2012 budget drafted in February 2011, the CFTC estimated that 140 entities may be covered by the definition of “swap dealer,” [1350] and after receiving additional information the CFTC estimates that approximately 125 entities will be covered by the definitions of the terms “swap dealer” and “major swap participant.” [1351] With these assumptions in mind, we believe it is reasonable to estimate that for every entity covered by the definitions, there will be about four entities (i.e., approximately four times 120, or about 450) that are sufficiently uncertain about the coverage of the definitions that they would incur costs in applying the definitions.

Our estimate that there would be about 450 such entities is also in line with the number of entities that were sufficiently interested in the Proposing Release that they submitted substantive comments to the CFTC. As noted above, we received about 300 substantive comment letters in response to the proposal. Of these, some reflected more than one letter from a single commenter, comments from persons who did not expect to be swap dealers, or comments from persons who were not uncertain about their status under the definition. On the other hand, several letters were from multiple commenters that submitted their comments jointly. Thus, we estimate that about 225 entities were sufficiently interested in the proposed rule further defining the term “swap dealer” that they submitted a substantive comment, and for each such entity there was another entity that would also be similarly uncertain about the definition, which supports our estimate that 450 entities in total would incur costs in applying the definition.

Regarding the determination of whether an entity is eligible for the de minimis exception from the definition of the term “swap dealer,” we note that only an entity that is engaged in some swap dealing activity would be required to make this determination, but it would be required to make the determination regardless of whether it is uncertain about whether its swap activities constitute dealing (e.g., it would incur costs even if there were no doubt that it is engaged in swap dealing). We also note that the number of entities that will apply the de minimis exception is expected to be significantly greater than the number of entities that are required to register as swap dealers. Again, we believe that the entities making this determination would have situations that are highly complex (we believe approximately 25 entities would fall in this category), moderately complex (approximately 200 entities) and of low complexity (approximately 400 entities). [1352] The direct cost of making the determination for these entities would be approximately $42,000 in highly complex situations, [1353] $15,000 in moderately complex situations [1354] and $8,000 in situations of low complexity. [1355] The total direct costs for all entities would be approximately $7,300,000.

Third, regarding the determination of whether an entity should apply for a limited purpose swap dealer registration, we believe that relatively few entities would make such an application but that the situation of each of these entities would be highly complex. We believe approximately 20 entities would fall in this category, and the direct cost of making the determination for each would be approximately $250,000, [1356] resulting in a total direct cost of approximately $5,000,000.

Thus, the total initial direct cost of applying the rules further defining the term “swap dealer” (including the de minimis exception and the possibility of limited purpose registration) for all entities would be approximately $32,000,000.

In addition to these initial costs, we believe that entities would incur recurring costs in applying the definition. Regarding the application of the term “swap dealer,” we estimate that approximately 10 percent of the entities noted above would, each year, experience significant changes in their usage of swaps (such as beginning or ending a new line of business) that would require reconsideration of the application of the definition, which would result in costs amounting to one-half of the direct cost of making the initial determination. Applying these factors to the costs noted above, the total recurring direct costs for all entities associated with the application of the term “swap dealer” are estimated to be approximately $1,000,000 per year. Regarding the de minimis exception, we estimate that entities would have to incur ongoing costs of review to determine whether the exception applies on a yearly basis, and that the annual cost of this review would amount to one-half of the direct cost of making the initial determination. That is, the total recurring direct costs for all entities associated with the de minimis exception are estimated to be approximately $3,700,000. Last, we estimate that entities that qualify for a limited purpose swap dealer registration would incur ongoing review costs amounting to one-quarter of the direct cost of making the initial determination, or approximately $1,300,000 per year. Thus, the total recurring direct cost of applying the swap dealer definition (including the de minimis exception and the possibility of limited purpose registration) would be approximately $6,000,000.

5. Costs and Benefits of the Rules Further Defining “Major Swap Participant”

This Adopting Release further defines a “major swap participant” by setting out quantitative thresholds against which a market participant can compare its swaps activities to determine whether it is encompassed by the definition. The rule requires potential major swap participants to analyze their swaps in detail to determine, for example, which of their swaps are subject to netting agreements or mark-to-market collateralization, and the amount of collateral posted with respect to the swaps. The rule includes a general, qualitative definition of the swaps that may be excluded from the calculation because they are used to “hedge or mitigate commercial risk.” Like the swap dealer definition, there is a voluntary process by which a person may request that the CFTC limit the major swap participant designation to certain categories of swaps.

a. Background

The definition set forth in CEA section 1a(33) provides that the term “major swap participant” means any person who is not a swap dealer and (i) maintains a substantial position in swaps for any of the major swap categories as determined by the CFTC; (ii) whose 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 (iii) is a financial entity that is highly leveraged relative to the amount of capital it holds, is not subject to capital requirements established by an appropriate Federal banking agency, and maintains a substantial position in outstanding swaps in any major swap category as determined by the CFTC. In connection with the calculation of “substantial position” noted above, the statutory definition specifically excludes positions held for hedging or mitigating commercial risk, and positions maintained by any employee benefit plan as defined in sections 3(3) and (32) of ERISA for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan. The statutory definition also provides that major swap participant designations may be limited in scope so that a person may be designated as a major swap participant in certain, but not all, swap categories.

CEA section 1a(33)(D) excludes from the definition of the term “major swap participant” certain entities whose primary business is providing financing and who use derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company. There is no analogous statutory provision applicable to major security-based swap participants.

As detailed in this Adopting Release, the definition of the term “major swap participant” focuses on the market impacts and risks associated with a person's swap positions. This contrasts to the definition of the term “swap dealer,” which focuses on a person's activities and accounts for the amount or significance of those activities only in the context of the de minimis exception. Persons that meet the major swap participant definition would, in large part, follow the same statutory requirements applicable to swap dealers. [1357] In this manner, the Dodd-Frank Act regulates entities whose swap activities do not cause them to be swap dealers, but nonetheless could pose a high degree of risk to the U.S. financial system. This regulation of major swap participants is intended to facilitate financial stability by reducing risk, increasing transparency, and promoting market integrity.

b. Costs of Applying the Rules Further Defining the Term “Major Swap Participant”

The actual cost of applying the rule further defining the term “major swap participant” to determine if a person is covered by the definition will depend, in large part, on the nature of the person's swap activities as well as the infrastructure such person already has in place for the analysis and reporting of its swap activities. Many persons will be clearly outside the definition (and a few persons may be clearly covered by the definition) and will incur little cost to confirm that status. However, it is reasonable to expect that a few persons that are not swap dealers but nonetheless engage in significant swap activity will be required to incur costs to determine whether they are covered by the definition. The direct costs such a person would incur would result from the incremental expense of personnel with financial and accounting expertise who would be required to devote time to the review of the size and nature of the person's swap positions to determine whether the person is covered by the definition. Moreover, there will also be technology and legal review costs related to the determination of whether a person is a major swap participant. As is the case for the definition of the term “swap dealer,” it is important to recognize that even in the absence of any rule further defining the term “major swap participant,” or regardless of the terms of the rule, entities would incur costs in interpreting the statutory definition to determine whether they are covered. Thus, at a minimum, a significant portion of the costs discussed below is attributable to the inclusion in the Dodd-Frank Act of a definition of the term “major swap participant” and not from any aspect of the final rules further defining that term. Indeed, the final rules provide benefits by mitigating these costs by providing guidance about the application of the statutory definitions in different situations.

The amount of time and resources that must be expended by a person in order to determine whether it qualifies as a major swap participant may vary considerably depending on the complexity of such person's operations. In addition, direct costs will vary depending on the determinations the person must make relating to the definition, including, but not limited to, whether it engages in swap activity near the thresholds for “substantial position” and “substantial counterparty exposure,” and whether it is subject to a “safe harbor” provision as set forth in the definition. The CFTC did not receive any comments quantifying the costs that a person may incur in applying any aspect of the definition of the term “major swap participant,” nor are we aware of any studies or surveys regarding this particular issue. Therefore, the CFTC staff has estimated, based on its experience, the amount of time that a person may require to determine whether it meets the definition. These estimations are for informational purposes and require the CFTC to consider the aforementioned highly uncertain criteria.

The CFTC estimates that approximately 20 persons that are not swap dealers will initially be engaged in swap activity to such an extent that they would be required to apply the calculations in the final rule in determining whether they are covered by the definition. [1358] The direct cost of making such determination for each such person is estimated to be approximately $260,000, [1359] resulting in an initial aggregate direct cost of approximately $5,200,000. We note that the relatively low estimate of only 20 persons that would be required to incur costs at this level, as compared to the many thousands of swap market participants, reflects the relatively high thresholds for major swap participant status. As noted above, the large majority of market participants will be able to readily conclude that they are not covered by the definition.

In addition to these initial costs, we believe that approximately 20 entities would incur recurring direct costs in applying the definition of major swap participant on a daily basis, and such costs would amount to one-third of the direct cost of making the initial determination. Thus, the total recurring direct costs for all entities associated with the application of the term “major swap participant” are estimated to be approximately $1,700,000 per year or approximately $83,000 per year for each person.

Although the CFTC believes there will only be a limited number of persons that potentially may be major participants, we recognize the concerns raised by several commenters that major swap participant calculations will be conducted as part of the person's overall compliance function even when there is not a significant likelihood that such person would be a major swap participant. As a result of the potential expense and effort that a person would be required to incur in connection with determining whether it meets the definition of major swap participant, the final rule includes three alternative “safe harbor” provisions. [1360] These safe harbor provisions relieve persons that are clearly not major swap participants from incurring the expense of the calculations otherwise required under the final rule.

To apply the safe harbor provisions of the rule, the CFTC estimates that a person would have to incur initial direct costs of approximately $2,900 to determine whether its swap positions are within the safe harbor. [1361] In addition, a person would incur costs of reviewing its swap positions on a monthly basis to monitor whether the safe harbor continues to apply, at an annual cost equal to one-third of the direct cost of making the initial determination, or $960. Our assumption that approximately 1,200 entities would apply the safe harbor provisions of the rule yields an aggregate direct initial cost of approximately $3,500,000 and aggregate annual costs of approximately $1,200,000. [1362]

c. Major Swap Participant Thresholds

The final rule adopts the general approach in the proposed rule of determining whether a person is a major swap participant by comparing the exposure resulting from a person's swap positions to specific, quantitative thresholds. The proposed thresholds for substantial position were $3 billion in current uncollateralized exposure or $6 billion in current uncollateralized exposure plus potential future exposure for rate swaps, and $1 billion in current uncollateralized exposure or $2 billion in current uncollateralized exposure plus potential future exposure for each of the other categories of swaps. The proposed thresholds for substantial counterparty exposure are $5 billion in current uncollateralized exposure across all categories or $8 billion in current uncollateralized exposure plus potential future exposure across all categories. [1363] However, there is a change for the weight in the PFE calculations from the proposal to the final rule of 0.2 to 0.1 for cleared swaps.

Commenters generally did not oppose the proposed thresholds although several thought the thresholds should be raised. [1364] Two commenters supported the adoption of the thresholds as proposed. [1365] In addition, a few other commenters thought that the thresholds were set too high. [1366] Other commenters suggested that the thresholds be raised to a level that reflects systemic risk without suggesting a specific numerical threshold. [1367] One commenter, however, suggested that the threshold be increased to $10 billion. [1368] Several commenters also said that the thresholds should be adjusted for inflation and other changes over time in the swap market. [1369]

As discussed in part IV.B.3.d., the CFTC is adopting the thresholds as proposed. We recognize that the level of the thresholds will have a significant effect on whether the rules further defining the term “major swap participant” are applied in a manner that is more or less inclusive, and that in setting the thresholds it is possible that we may err on the side of over- or under-inclusion. As noted above in part V.C.2., if the rule were more inclusive, costs could arise when the persons that are classified as major swap participants incur compliance costs, while if the rule is less inclusive the benefits of regulating major swap participants (in terms of reduced risk, increased transparency and market integrity) could be reduced. We also recognize that a more inclusive rule could lead to costs if it causes persons to make changes to their use of swaps in order to avoid being covered by the rule.

One commenter said that the CFTC should conduct an empirical analysis of the proposed thresholds and whether they are suitable for identifying persons whose swap positions entail the risks enumerated in the statutory definition of the term “major swap participant.” [1370] However, the CFTC believes it is not feasible to perform such an analysis because the comprehensive and detailed information about how very active swap market participants use swaps that it would require is not available.

The CFTC believes that the threshold levels in the final rule are appropriate to effectively monitor and oversee entities that are systemically important or could significantly impact the U.S. financial system. The CFTC and SEC are consistent in their approach to thresholds. As more data regarding the use of swaps and the importance of very large swap positions in the swap markets become available, the CFTC may consider adjusting the thresholds.

The final rules also provide for the measure of potential future exposure to be adjusted in the case of swap and security-based swap positions that are centrally cleared or that are subject to daily mark-to market margining. This is consistent with the purpose of the potential future exposure test, which is to account for the extent to which the current outward exposure of positions (though possibly low or even zero at the time of measurement) might grow to levels that can lead to high counterparty risk to counterparties or to the markets generally. The practice of the periodic exchange of mark-to-market margin between counterparties helps to mitigate the potential for large future increases in current exposure.

Consistent with the proposal, the final rules reflect this ability to mitigate risk by providing that the potential future exposure associated with positions that are subject to daily mark-to-market margining will equal 0.2 times the amount that otherwise would be calculated. However, in response to commenters assertions about the risk-mitigating effects of central clearing, and the additional level of rigor that clearing agencies may have with regards to the process and procedures for collecting daily margin, the final rules further provide that the potential future exposure associated with positions that are subject to central clearing will equal 0.1 (rather than the proposed 0.2) times the potential future exposure that would otherwise be calculated. [1371]

Although some commenters supported the complete exclusion of cleared positions from the potential future exposure analysis, [1372] the CFTC recognizes that central clearing cannot reasonably be expected to entirely eliminate counterparty risk. [1373] Accordingly, the CFTC concluded that the use of a 0.1 factor (in lieu of the proposed 0.2) is appropriate for cleared positions, reflecting the strong risk mitigation features associated with central clearing, particularly the procedures regarding the collection of daily margin and the use of counterparty risk limits, while recognizing the presence of some remaining counterparty risk.

Moreover, although some commenters opposed any deduction from the measure of potential future exposure for uncleared positions that are margined on a daily basis, [1374] the CFTC believes that the risk-mitigating attributes of daily margining warrant an adjustment given that the goal of the potential future exposure test is to account for price movements over the remaining life of the contract. [1375] The use of a 0.2 factor also reflects the CFTC's expectation that the risk mitigation associated with uncleared but margined positions would be less than the risk mitigation associated with cleared positions.

While higher or lower alternatives to the 0.1 and 0.2 factors may also be reasonable for positions that are cleared or margined on a daily basis, the CFTC believes that the factors of the final rules reasonably reflects the risk mitigating (but not risk eliminating) features of those practices. The final rules also retain and clarify provisions addressing when daily mark-to-market margining occurs for purposes of this discount. [1376]

d. Difficulty in Applying the Major Swap Participant Calculations

While commenters generally acknowledged that the proposed quantitative threshold tests are objective, some said that the proposed tests are difficult to understand and hard to apply. [1377] Another commenter submitted that “[the CFTC] should solicit feedback from market participants prior to final rule given the complexity of tests and likely interpretive issues; proposed tests are highly technical, and more challenging to use than may appear at first glance; could also request volunteers to walk-through the tests to ensure they actually function in practice.” [1378] Several commenters suggested means of reducing the costs of applying the proposed tests. Some commenters requested that the CFTC adopt a “safe harbor” provision in the final rules for swap users with positions that are substantially below the thresholds. [1379] Another commenter opined that the rule should allow persons to rely on third-party service providers to conduct the required calculations. [1380] In addition, a commenter said the rule should allow swap users to apply standard industry practices in valuing their positions. [1381]

We believe that the guidance in this Adopting Release reduces the costs of determining if a person is covered by the definition. For example, in response to commenters' concerns we clarify that a person may determine the value of its exposure using industry standard practices. [1382] Also, we believe that the daily calculation burdens associated with the proposed thresholds will be addressed by safe harbors that are available if a simplified calculation shows that a person's exposure from its swap position is far below any threshold for any particular month. The final rule includes safe harbors to reduce unnecessary costs for entities that, because of compliance concerns, would engage in major swap participant calculations even though it would be very unlikely that the major swap participant thresholds would be met. [1383] Also, the CFTC will permit third-party service providers to perform major swap participant calculations, although a person that may be a major swap participant is not relieved of potential liability for violations of the CEA if there is a calculation or other error by the third-party. [1384]

e. Exclusions for Particular Types of Entities

Commenters said that exclusions from the major swap participant definition should be available for certain entities including insurance companies, registered investment companies, entities that maintain legacy portfolios of swaps, ERISA plans, and sovereign wealth funds. [1385] Some commenters cited, as the underlying basis for excluding these entities, the existing regulatory regime to which these entities are subject and the potential for dual regulation if they were covered by the definition of the term “major swap participant.” [1386] One commenter asserted that a lack of clarity with respect to proposed exemptive relief will impose additional costs on market participants due to the uncertainty in determining major swap participant status. [1387]

Several commenters said that sovereign wealth funds should be excluded from the definition of major swap participant based on international principles of comity and sovereign immunity. [1388] These commenters asserted that sovereign wealth funds are regulated in their home country and do not represent the type of counterparty risk contemplated by the Dodd-Frank Act. A commenter asserted that special purpose vehicles for structured finance or securitization should be exempted from the definition of major swap participant so as to not harm liquidity in asset securitizations. [1389] That commenter based its recommendation on the understanding that special purpose vehicles have limited functionality and resources and would accordingly be unable to comply with the burden of regulation as a major swap participant. [1390]

The final rule does not have specific exclusions for certain types of entities. The CFTC believes that a more level playing field is desirable to ensure no particular type of entity gains an unfair competitive advantage in the market.

The appropriate treatment of “legacy portfolios” (e.g., the monoline insurers or their special purpose vehicles) will be determined on a case-by-case basis by the CFTC. Legacy portfolio operators specifically commented that they are in “run-off”/wind down mode, thereby undertaking no new swaps that would increase their risk, with an expectation to shut down or cease operations once their portfolio expires. [1391] As a result, these commenters maintain that margin or capital requirements would likely lead to their insolvency because they do not have the assets to satisfy the proposed requirements. The CFTC notes that many of the compliance obligations imposed by the Dodd-Frank Act and/or the business conduct rules promulgated thereunder will not apply to operators of legacy portfolios because such obligations will not be applicable to swaps executed prior to the enactment of the Dodd-Frank Act such as the swaps in legacy portfolios. [1392] Consequently, the CFTC expects legacy portfolio operators' primary compliance obligation to be related to reporting and risk management.

f. CEA Section 15(a) Discussion

The costs and benefits of the rule further defining the term “major swap participant” are evaluated in light of the section 15(a) five broad areas of market and public concern.

Protection of market participants and the public. The rule helps parties to identify when they have substantial positions or substantial counterparty exposures in swap markets that would cause them to be covered by the definition of major swap participant. Under the Dodd-Frank Act, major swap participants are subject to regulations enacted to protect market participants and the public. The costs and benefits of the statutory and regulatory requirements for major swap participants are addressed in the various rulemakings in which they are promulgated. [1393]

Efficiency, competitiveness, and financial integrity of markets. To date, potential major swap participants have engaged in swaps in an off-exchange marketplace that has been largely unregulated. Once the regulations required under the Dodd-Frank Act are adopted and effective, major swap participants will be subject to CFTC oversight and comprehensive regulation. The CFTC believes these regulations will improve the financial integrity of swap markets and the U.S. financial system generally. Since the number of persons that are expected to be major swap participants is small, the CFTC believes that these regulations will not have a significant effect on the efficiency or competitiveness of the markets.

Price discovery. The CFTC does not perceive any direct effect on price discovery from the rule further defining the term “major swap participant.”

Sound risk management practices. The level of the major swap participant thresholds may discourage persons from engaging in swap activities that might cause them to exceed the major swap participant thresholds. This reduction in the use of swaps could be costly if other alternatives are not as suitable for the underlying risks (e.g., futures might have different contract sizes or expiration, and forward contracts introduce physical risks not present in cash settled transactions). The CFTC notes that this concern is mitigated by the relatively high threshold levels for major swap participant status.

Other public interest considerations. The specific quantitative thresholds in the rule set forth definitive tests for determining if a person is covered by the definition of the term “major swap participant.” This specific, quantitative threshold serves the public interest by promoting efficient application of the rule. Also, as noted above, major swap participants will be subject to CFTC oversight and comprehensive regulation, which we believe will improve the financial integrity of swap markets and the U.S. financial system generally.

6. Costs and Benefits of the Rules Relating to the Definition of “Eligible Contract Participant”

a. Background

The ECP regulations and interpretation fall within the following six categories:

  • CFTC Regulation § 1.3(m)(5)(i) prevents a commodity pool (i) in which any of the pool's direct participants is not an ECP in its own right and (ii) that directly enters into retail forex transactions from being an ECP under CEA section 1a(18)(A)(iv) or (v), for purposes of retail forex transactions only. CFTC Regulation § 1.3(m)(5)(ii) provides that the CFTC would look through a commodity pool participant that directly participates in a transaction-level commodity pool only if such direct commodity pool participant, any entity holding an interest in such direct commodity pool participant, or any entity in which such direct commodity pool participant holds an interest were structured to evade subtitle A of Title VII of the Dodd-Frank Act by permitting persons that are not ECPs to participate in retail forex transactions. The look-through in CFTC Regulation § 1.3(m)(5)(ii) does not apply to a non-commodity pool participant in a commodity pool.
  • CFTC Regulation § 1.3(m)(6) excludes a commodity pool from ECP status if it does not have total assets exceeding $5,000,000 or is not operated by a person described in CEA section 1a(18)(A)(iv)(II). [1394]
  • CFTC Regulations § 1.3(m)(1)-(4) define major swap participants, swap dealers, major security-based swap participants and security-based swap dealers, respectively, as ECPs.
  • CFTC Regulation § 1.3(m)(7) permits an otherwise non-ECP to qualify as an ECP, with respect to certain swaps, based on the collective net worth of its owners, subject to several conditions, including that the owners are ECPs.
  • CFTC Regulation § 1.3(m)(8) permits a Forex Pool to qualify as an ECP notwithstanding that it has one or more direct participants that are not ECPs if the Forex Pool (a) is not formed for the purpose of evading regulation under CEA sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b) has total assets exceeding $10 million and (c) is formed and operated by a registered CPO or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3).
  • Finally, the Commissions have provided an interpretation to address an incorrect statutory cross-reference preventing certain government entities from qualifying as ECPs under CEA section 1a(18)(A)(vii). [1395]

b. Summary of Comments

Commenters stated that commodity pools will incur costs to comply with statutory and regulatory requirements made applicable as a result of the Commissions' narrowing of the ECP definition. [1396] Commenters argued that to apply the look-through at any investment level would be unnecessarily burdensome and disruptive to how commodity pools are structured, with resulting costs. [1397] One commenter advised that, if a trading advisor cannot be sure that all pool participants are ECPs, then it must be cautious and either register as a CPO or decide not to engage in Retail Forex Transactions on behalf of its advised pools. [1398] Another commenter stated that while many existing commodity pools have already obtained accredited investor and QEP representations from participants, virtually none currently obtain ECP representations from their investors. [1399] This commenter argued that obtaining such a representation would impose an operational burden and additional costs, as well as require commodity pools to redeem non-ECPs. The commenter further points out that, given the estimated $1.9 trillion of assets invested in hedge funds, the portion of those assets that use OTC forex is likely to be substantial, and therefore substantial time and expense would be expended in determining eligibility requirements for the thousands of investors in funds that use OTC forex. [1400]

Commenters explained that there are costs to losing ECP status and that the enumerated counterparty list is unclear and subject to uncertainty because it relies on other regulators. [1401] One commenter argues that funds would incur compliance and transaction costs if categorized as non-ECPs because they would have to enter into forex transactions through a DCM and their operators would have to register as CPOs. [1402] That commenter also states that the markets for exchange-traded futures are less liquid than OTC forex markets, and that posting initial margin on a DCM is costly, since it cannot be used to invest in riskier assets and a FOF would have to invest in liquid and low risk (and, commensurately, lower yielding) assets necessary to post variation margin. As another commenter points out, the resulting increased expenses from the requirement to trade on a DCM and comply with retail forex rules may result in higher expenses for hedge and private equity funds, which they would likely pass along to their investors. [1403]

A commenter asserted that the characteristics necessary to avoid non-ECP status may prevent free investment and could reduce liquidity and create volatility in these markets. [1404]

With respect to CFTC Regulation § 1.3(m)(6), a commenter expressed concerns with the expected costs associated with the proposal that commodity pools that do not qualify as ECPs under clause (A)(iv) should not be able to qualify under clause (A)(v), stating that the proposal would be difficult to comply with and would adversely impact investment. [1405]

Two commenters agreed that the proposed addition of swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants to the ECP definition provided a benefit with little or no costs. [1406] No commenter objected.

With respect to CFTC Regulation § 1.3(m)(7), commenters said that non-ECPs have entered into swaps in reliance on the Swap Policy Statement. [1407] Commenters emphasized the importance of the Swap Policy Statement to pass-through entities used by farmers, [1408] operating companies [1409] and commercial property developers, [1410] noting that such entities may not meet the ECP criteria. According to these commenters, these pass-through entities often are small and medium-sized businesses that enter into interest rate swaps with lending financial institutions in reliance on the Swap Policy Statement. [1411] The commenters explained that the loans usually are guaranteed by the principals of the entity entering into the swap, and that the borrower would qualify as an ECP if structured as a single-level corporate entity or sole proprietorship. [1412] Commenters said that if these non-ECP entities were limited to swaps that are available on or subject to the rules of a DCM, many regional bank borrowers would lose the ability to use swaps, real estate companies would have less flexibility in risk management, and smaller lenders would be at a competitive disadvantage. [1413] Another commenter said that Dodd-Frank Act provisions such as the end-user clearing exception indicate that Congress intended to preserve the availability of swaps used for managing risks rather than for investment or speculation. [1414]

To mitigate the impact of restricting non-ECPs to swaps that are available on or subject to the rules of DCMs, some commenters said that an entity should be able to qualify as an ECP based on the financial qualifications of related entities, so long as various conditions proposed by the commenters are satisfied. Some commenters said that an entity should be eligible to be an ECP if its swap obligations are guaranteed by an ECP, [1415] or if its controlling entity qualifies as an ECP under clause (A)(v) of the statutory definition. [1416] Another commenter suggested revisions to the ECP definition that included looking to the ECP status or sophistication of the majority owner of an entity in determining if the entity itself is an ECP. [1417] Other commenters suggested other provisions to allow non-ECPs to enter into swaps other than on or subject to the rules of a DCM, so long as the non-ECP meets various conditions indicating that the swap is used in connection with its line of business. [1418]

With respect to CFTC Regulation § 1.3(m)(8), several commenters asserted that many Forex Pools are operated by sophisticated, professional managers that do not need the protections of a retail forex regime designed to protect non-ECPs that are engaging in retail forex transactions. [1419] More specifically, some commenters, based on CFTC enforcement actions involving Forex Pools, suggested that commodity pools of a sufficient size, and/or operated by a registered or exempt CPO, do not pose the risks of fraud and abuse of non-ECP customers that the statutory look-through provision is intended to address. [1420]

As a result, commenters suggested that the look-through provision should not apply in determining ECP status of commodity pools that meet certain conditions. For example, commenters suggested that the look-through not be applied to a commodity pool with $10 million in total assets if other factors were present—e.g., not structured to evade, [1421] subject to regulation under the CEA [1422] and/or operation by a registered CPO. [1423] Another commenter suggested requiring the total assets or minimum initial investment of a Forex Pool to be sufficiently large that, in general, only legitimate pools would exceed such thresholds. [1424] This commenter suggested a total asset threshold of $50 million. [1425]

Separately, one commenter also claimed that the statutory look-through, if strictly implemented, might inappropriately preclude Forex Pools and their CPOs, many of whom are registered, from engaging in retail forex transactions with swap dealers because swap dealers are not Enumerated Counterparties (and some swap dealers also may not be Enumerated Counterparties in a different capacity, such as being a U.S. financial institution). [1426] This commenter stated that such a result could reduce close out netting opportunities in the event of the insolvency of a counterparty.

Finally, to reduce the adverse effects on government entities that may need to qualify as ECPs based on their swap counterparties but that would be foreclosed from doing so due to an erroneous reference in the definition of ECP, a commenter requested the correction of that erroneous reference. [1427]

c. Response to Comments and Consideration of Costs and Benefits in the Final Rule

CFTC Regulation § 1.3(m)(5)(i) reduces the number of pools that need to determine the ECP status of their natural person participants, and thus reduces related costs, because it limits, absent evasion, the pools the CFTC considers for look-through purposes to transaction-level retail forex pools. The guidance the Commissions provide in the preamble also reduces the scope of the potential look-through, with attendant cost-reductions, by stating expressly that a Retail Forex Pool using retail forex transactions solely to hedge or mitigate currency risk would not be considered structured to evade. Thus, such hedging or mitigation would not be the basis of a look-through. In particular, because, according to a commenter, the typical FOF uses retail forex transactions solely to hedge currency risk related to fluctuations in the exchange rate between non-U.S. dollar subscription currencies and the U.S. dollar, most, if not all, FOFs would not be covered by the look-through. To the extent other commodity pools use retail forex transactions solely to hedge or mitigate their currency risk, such pools also would not be subject to the CFTC Regulation § 1.3(m)(5)(ii) look-through provision. Because Regulation § 1.3(m)(5)(ii) provides a look through only in cases of evasion and the Commissions' guidance narrows considerably the scope of what might otherwise be considered evasion, the CFTC expects the CPO of the typical pool to be able to determine at little or no cost the ECP status of their direct participant commodity pools; such status will be based on CEA section 1a(18)(iv), an analysis with which such CPOs are familiar. [1428]

While the CFTC has provided guidance to reduce the costs of applying the rule, it estimates that each affected CPO may have to spend between 5 and 20 hours of legal time, representing a cost between $1,800 and $7,100, [1429] initially to determine the ECP status of the pools that they operate, and up to 5 hours ($1,800) of additional legal time to determine such status upon each change to the fund's structure, operating guidelines, etc. that might implicate ECP status. Commenters noted that drafting ECP representations and contacting existing participants are part of the costs of determining ECP status. While the CFTC acknowledges such costs, CFTC Regulation § 1.3(m)(5) also provides investor protection benefits to non-ECP participants in pools that are not ECPs by requiring such pools to enter into retail forex transactions with an Enumerated Counterparty. This provides non-ECP participants in such pools the protections of the retail forex regime imposed by such counterparty's federal regulator.

The CFTC also notes that the number of categories of enumerated counterparties available as counterparties to non-ECP commodity pools has increased since the Commissions proposed the regulations, because other regulators have finalized their retail forex regimes, as discussed in greater detail above. While trading with Enumerated Counterparties will entail doing so pursuant to the retail forex regulations of the relevant federal regulator, such regulations will apply to the counterparties, not the CPO. While CPOs of Retail Forex Pools generally must register as such with the CFTC, to the extent an exemption from registration is available under the CFTC's rules, such CPOs need not register as a result of their retail forex transactions, further reducing the potential costs of Regulations §§ 1.3(m)(5)(i) and (ii). Further, commodity pools will not incur any costs to change counterparties (with the accompanying costs of, for example, putting in place new trading documentation) to the extent they already trade with Enumerated Counterparties. Commenters noted that non-ECP pools would incur costs to negotiate new trading documentation with Enumerated Counterparties to the extent that such pools do not currently enter into retail forex transactions with Enumerated Counterparties and wish to continue to engage in retail forex transactions other than on or subject to the rules of a DCM. However, Regulation § 1.3(m)(5) also provides investor protection benefits to non-ECP participants in pools that enter into retail forex transactions by requiring such pools to trade with Enumerated Counterparties and to be operated by registered CPOs, absent an applicable exemption.

To the extent that a commodity pool is precluded by CFTC Regulation § 1.3(m)(6) from achieving ECP status based on prong (A)(v) of the ECP definition, the pool will be limited to trading swaps, if at all, on or subject to the rules of a DCM. This could result in costs to affected commodity pools, including margin, the costs of establishing relationships with future commission merchants (e.g., reviewing new account opening documentation) and opportunity costs from losing the ability to trade swaps customized to pools' needs. Preventing commodity pools that do not qualify under clause (A)(iv) from qualifying pursuant to clause (v), however, closes a loophole that would allow smaller commodity pools that are not able to satisfy the requirements of clause (A)(iv) of the ECP definition to qualify as ECPs. Moreover, by providing additional clarification in the preamble regarding the meaning of CEA section 1a(18)(A)(iv)(II), the Commissions substantially reduced the potential number of commodity pools affected by CFTC Regulation § 1.3(m)(6).

CFTC Regulations §§ 1.3(m)(1)-(4) define major swap participants, swap dealers, major security-based swap participants and security-based swap dealers, respectively, as ECPs. Stating explicitly in regulations that these entities are ECPs avoids the potentially anomalous result of such entities, which are some of the largest and/or most active swap market participants, not being ECPs and is in line with expectations in the market that these entities may engage in a full range of swap and security-based swap activities. The CFTC believes that these regulations will not result in any significant economic costs or benefits.

The CFTC is persuaded by commenters that allowing participants to continue to rely on the line of business element of the Swaps Policy Statement will mitigate unnecessary costs from the regulation but is adding various conditions to retain adequate protection for market participants and the public. As noted above, CFTC Regulation § 1.3(m)(7) permits an entity, in determining its net worth for purposes of subclause (A)(v)(III) of the ECP definition, [1430] to include the net worth of its owners, solely for purposes of determining its ECP status for swaps used to hedge or mitigate commercial risk, provided that all of its owners are themselves ECPs (disregarding shell companies, as defined above). Under CFTC Regulation § 1.3(m)(7) as adopted, an entity seeking to qualify under subclause (A)(v)(III) of the ECP definition in order to enter into a swap used to hedge or mitigate commercial risk is permitted to count the net worth of its owners in determining its own net worth, so long as all its owners are ECPs. Accordingly, CFTC Regulation § 1.3(m)(7) will allow qualified participants the flexibility to enter into customized swaps.

By limiting the line of business ECP prong to entities owned solely by ECPs, the CFTC is preserving the intent behind the ECP requirement, which is to limit the availability of customized swaps to market participants of sufficient financial sophistication and with sufficient assets or net worth to assess, appreciate and bear the implications and risks of swap transactions. Although commenters proposed various solutions to address the loss of the Swap Policy Statement, the CFTC believes the approach adopted is the best approach; it substantively preserves the ECP requirement and protects the real parties in interest (i.e., the owners). Although banks and non-ECP borrowers might be able to restructure or more highly capitalize borrowing entities or borrow at a higher level in the ownership structure, this regulation will allow banks and qualified businesses to continue to conduct their loan arrangements as usual without incurring the costs, which could include undesirable tax treatment, of such operational changes. Further, because commenters focused on swap related risks, the Commissions limited this regulation's application narrowly, i.e., it does not apply for purposes of determining ECP status for: swaps not meeting the conditions set forth in Regulation § 1.3(m)(7); security-based swaps; security-based swap agreements; mixed swaps; or agreements, contracts or transactions that are not swaps (regardless of the purpose for which they are used).

CFTC Regulation § 1.3(m)(8) permits a Forex Pool to qualify as an ECP notwithstanding that it has one or more direct participants that are not ECPs if the Forex Pool (a) is not formed for the purpose of evading regulation under CEA sections 2(c)(2)(B) or (C) or related rules, regulations or orders, (b) has total assets exceeding $10 million and (c) is formed and operated by a registered CPO or by a CPO who is exempt from registration as such pursuant to CFTC Regulation § 4.13(a)(3). The data presented by commenters, discussed above, demonstrate that registered CPOs [1431] of commodity pools over a certain size ($10 million in total assets) historically have engaged in retail forex misconduct to a much less significant degree than other CPOs. Only one of the 45 unique cases presented by commenters involved a pool with more than $10 million in total assets and a registered CPO. Only two of those cases involved a pool operated by CPOs exempt from registration: in both of those cases, however, the CPO raised less than $10 million. [1432] The CFTC also recognizes that subjecting such commodity pools to the statutory look-through provision to protect non-ECP customers from fraud and abuse would cause them to incur higher costs (e.g., CPO compliance costs for those CPOs required to register as such, and redocumenting trading relationships with new counterparties who are Enumerated Counterparties), for intangible pool participant protections. To further protect pool participants, the Commissions added a requirement that, to be an ECP under the line of business prong, the Forex Pool must not be formed for the purpose of evading CFTC regulation of Retail Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B) or (C). Accordingly, the Commissions have tailored CFTC Regulation § 1.3(m)(8) in a manner they believe preserves its ability to effectively protect market participants and the public, while avoiding significant costs.

As noted above, CEA section 1a(18)(A)(vii)(cc) contains a statutory cross-reference rendered incorrect due to a legislative drafting oversight. Failing to address such error would inappropriately deprive such entities of ECP status, imposing undue costs (e.g., the opportunity costs of being unable to execute a desired hedge or trading strategy using standardized exchange-traded swaps) on such entities. Allowing a government entity the ability to qualify as an ECP based on its counterparty's status will provide, at little or no cost, the benefit of effectuating Congressional intent that government entities satisfying the conditions of CEA section 1a(18)(A)(vii)(cc) be ECPs. Therefore, the CFTC included in the preamble an interpretation treating as an ECP government entities satisfying the conditions of CEA section 1a(18)(A)(vii)(cc) as if such section incorporated the correct cross-reference. The CFTC believes that correcting this incorrect cross-reference will not result in any significant economic costs or benefits.

d. CEA Section 15(a) Discussion

Protection of market participants and the public. Congress determined to protect retail foreign exchange investors from fraudsters by amending the ECP definition to require a pool's participants to qualify as ECPs for the pool to be an ECP under subsection (A)(iv). [1433] As discussed above, this protection, as implemented by CFTC Regulation § 1.3(m)(5) may raise the costs of legitimate foreign exchange transactions. To mitigate these potential increased costs, CFTC Regulations § 1.3(m)(5)(i) limits the look-through to the level of the commodity pool structure that engages in retail forex transactions, subject to CFTC Regulation § 1.3(m)(5)(ii). This limitation provides that, if any level of the pool has been structured to evade, the CFTC would look through the transaction-level commodity pool's direct commodity pool participants indefinitely until reaching non-commodity pool participants. CFTC Regulation § 1.3(m)(5), therefore, protects non-ECP members of the public in appropriate instances.

By limiting the line of business ECP prong to entities owned solely by ECPs, the CFTC is preserving the intent behind the ECP requirement, which is to limit the availability of customized swaps to market participants of sufficient financial sophistication to assess and appreciate the risk and implications of the transactions. Although commenters proposed various solutions to address the loss of the Swap Policy Statement, the CFTC believes the approach adopted is the best approach because it preserves the substance of the ECP requirement and protects the real parties in interest (i.e., the owners).

Because registered CPOs, [1434] and CPOs exempt from registration, who operate commodity pools over a certain size ($10 million in total assets) historically have engaged in retail forex misconduct to a much less significant degree than CPOs of commodity pools below that threshold, the CFTC believes that imposing this size threshold requirement as a condition of ECP status pursuant to Regulation § 1.3(m)(8) provides some protection to pool participants. The additional requirement that to be an ECP under the line of business prong the Forex Pool must not be formed for the purpose of evading CFTC regulation of Retail Forex Pools and retail forex transactions under CEA Section 2(c)(2)(B) or (C) will further protect pool participants.

Efficiency, competitiveness, and the financial integrity of the market. With respect to CFTC Regulation §§ 1.3(m)(5) and (6), commodity pools that do not qualify as ECPs may have to use products listed on or subject to the rules of a DCM that might not precisely (or at all) match such parties' needs. This may reduce or eliminate a commodity pool's ability to engage in some transactions, but these regulations also seek to prevent unsophisticated parties from entering into certain transactions to prevent repeated abuses and protect members of the public. We believe CFTC Regulations §§ 1.3(m)(1)-(8) do not significantly impact competitiveness or the financial integrity of markets.

Price discovery. CFTC Regulations §§ 1.3(m)(1)-(8) only clarify the status of entities. They do not affect price discovery.

Sound risk management practices. CFTC Regulations §§ 1.3(m)(5) and (6) may restrict investment opportunities for certain non-ECPs that might have otherwise qualified as ECPs. [1435] This may discourage the use of some sound risk management practices and/or investment strategies. For instance, it may become more expensive for CPOs operating non-ECP pools to use such practices and/or strategies if such pools must enter into swaps on or subject to the rules of a DCM or come into compliance with a retail forex regime or choose to redeem non-ECPs to avoid such results. On the other hand, CPOs may not incur the increased expense of such sound risk management practices and/or investment strategies if they are able to pass such costs on to the participants in the pools. Also, with respect to swaps, pools that are not ECPs due to CFTC Regulation § 1.3(m)(6) can enter swaps on or subject to the rules of a DCM to the extent an appropriate swap is listed by such DCM.

In contrast, CFTC Regulations §§ 1.3(m)(7) and (8) allow qualified participants to engage in swaps that are not on a DCM. This gives qualified participants more choices for their hedges, and may provide an opportunity for better risk management.

Other public interest considerations. CFTC Regulations §§ 1.3(m)(1)-(4) state that major swap participants, swap dealers, major security-based swap participants, and security-based swap dealers, respectively, are ECPs. The interpretive guidance regarding certain governmental ECPs remedies an incorrect statutory cross-reference with respect to the ability of a subset of governmental entities to qualify as ECPs under CEA section 1a(18)(A)(vii). [1436]

VIII. Administrative Law Matters—Exchange Act Revisions (Definitions of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant”) Back to Top

A. Economic Analysis

1. Overview

The SEC is sensitive to the costs and benefits of our rules. Some of these costs and benefits stem from statutory mandates, while others are affected by the discretion we exercise in implementing the mandates. We have requested comment on a