Introduction
The Securities and Exchange Commission (“SEC”) has proposed joint rules with the Commodity Futures Trading Commission (“CFTC”) that would further define a series of terms related to the swaps markets.
The Dodd-Frank Act divides regulatory authority over swaps between the SEC and the CFTC. The SEC has authority over “security-based swaps,” which are broadly defined as swaps based on (1) a single security or (2) a loan or (3) a narrow-based group or index of securities or (4) events relating to a single issuer or issuers of securities in a narrow-based security index. The CFTC has primary regulatory authority over all other swaps. The CFTC and SEC share authority over “mixed swaps,” which are security-based swaps with a commodity component.
Title VII of the Act authorizes the SEC to provide for the registration and regulation of security-based swap dealers and major security-based swap participants. Dealers and major participants would be subject to several statutory requirements, including those related to capital, margin and business conduct.
Caveat
In a vacuum, these definitions are somewhat meaningless. Hence this blog entry is really more useful for reference than as exposition of how swaps will be regulated under Dodd-Frank. However, we hope this will serve as the foundation for a more substantive future entry on swaps.
Definition of “Security-Based Swap Dealer”
The Dodd-Frank Act defines “security-based swap dealers” as persons who: (i) hold themselves out as a dealer in security-based swaps; (ii) make a market in security-based swaps; (iii) regularly enter into security-based swaps with counterparties as an ordinary course of business for their own account; or (iv) engage in activity causing themselves to be commonly known in the trade as a dealer or market maker in security-based swaps.
De Minimis Exemption from Definition of Security-Based Swap Dealer
The proposed rule exempts firms whose aggregate notional amount of security-based swaps over the prior 12 months does not exceed $100 million (of which no more than $25 million are with “special entities” (as defined in Exchange Act)) and have traded only up to 20 swaps with no more than 15 counterparties as a dealer within the prior 12 months.
Definition of “Major Security-Based Swap Participant”
The Dodd-Frank Act defines a “Major Swap Participant” as any person who is not a security-based swap dealer and: (1) who maintains a “substantial position” in any of the major security-based swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans, (2) whose outstanding security-based swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets,” or (3) who 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.
Definition of “Substantial Position”
The SEC proposes tests for both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a “substantial position.” The first “substantial position” test noted above would exclude positions hedging commercial risk and employee benefit plan positions from the substantial position analysis.
The proposed tests would apply to a person’s security-based swap positions in each of two major security-based swap categories: security-based credit derivatives and other security-based swaps.
First test of “Substantial Position” - Current
The first substantial position test in the proposed rules would: measure a person’s current uncollateralized exposure by marking the security-based swap positions to market using industry standard practices; allow the deduction of the value of collateral that is posted with respect to the security-based swap positions; and calculate exposure on a net basis, according to the terms of any master netting agreement that applies.
The proposed thresholds for the first test are a daily average current uncollateralized exposure of $1 billion in the applicable major category of security-based swaps.
Second test of “Substantial Position” - Potential
The second substantial position test would determine potential future exposure by: multiplying the total notional principal amount of the person’s security-based swap positions by specified risk factor percentages (ranging from 6% to 15%) based on the type of swap and the duration of the position; discounting the amount of positions subject to master netting agreements by a factor ranging between zero and 60%, depending on the effects of the agreement; and if the security-based swaps are cleared or subject to daily mark-to-market margining, further discounting the amount of the positions by 80%.
The proposed thresholds are $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major security-based swap category.
Definition of “Hedging or Mitigating Commercial Risk”
As noted above, the first test of the major participant definition excludes positions held for “hedging or mitigating commercial risk” from the substantial position analysis.
The proposed definition of “hedging or mitigating commercial risk” would encompass any non-speculative or traded security-based swap position that is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from a potential change in the value of: (i) assets that a person owns, produces, manufactures, processes, or merchandises, (ii) liabilities that a person incurs, or (iii) services that a person provides or purchases
Definition of “Substantial Counterparty Exposure”
The SEC proposes to define substantial counterparty exposure using a calculation method that is the same as the method used to calculate substantial position. However, the definition of substantial counterparty exposure is not limited to the major categories of security-based swaps, and it does not exclude hedging or employee benefit plan positions. Rather it encompasses all of a person’s security-based swap positions.
The proposed thresholds for substantial counterparty exposure are a current uncollateralized exposure of $2 billion, or a sum of current uncollateralized exposure and potential future exposure of $4 billion, across the entirety of a person’s security-based swap positions.
Definition of “Financial Entity” and “Highly Leveraged”
In determining whether a major security-based swap participant not subject to Federal banking agency capital requirements is “highly leveraged,” the SEC proposes to use the same definition of substantial position described above, without excluding hedging or employee benefit plan positions.
The SEC proposes to use the definition of “financial entity” that is based on the definition of that term in the Dodd-Frank Act provision for an end-user exception from mandatory clearing in Exchange Act Section 3C(g)(3). For the definition of “highly leveraged,” the SEC proposes either a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of 8 to 1, or a ratio of 15 to 1 measured in the same way.
Public Comment
The SEC is seeking public comment on the proposed rules for a period of 60 days following their publication in the Federal Register.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
