SEC Proposes Joint Rules with CFTC to Define Swap Related Terms
FOR IMMEDIATE RELEASE
Washington, D.C., Dec. 3, 2010 — The Securities and Exchange Commission today voted unanimously to propose joint rules with the Commodity Futures Trading Commission (CFTC) that would further define a series of terms related to the security-based swaps market, including “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”
The rules seek to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which among other things established a comprehensive framework for regulating the over-the counter swaps market.
SEC Chairman Mary L. Schapiro said, “Today’s proposals lay out objective criteria, but they are just a first step, as we seek public comment to help us appropriately address the market impacts and potential risks posed by these entities.”
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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The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter swaps markets. In particular, the Dodd-Frank Act divides regulatory authority over swaps between the SEC and the Commodity Futures Trading Commission (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, on the other hand, has primary regulatory authority over all other swaps.
- Meanwhile, the CFTC and SEC share authority over “mixed swaps,” which are security-based swaps that also have a commodity component.
Among other things, 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.
Title VII further provides that the SEC and the CFTC, in consultation with the Board of Governors of the Federal Reserve System, must work jointly to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.”
The joint proposal of the SEC and the CFTC in part would add new rules under the Securities Exchange Act of 1934 in connection with the definitions of “security-based swap dealer” and “major security-based swap participant.”
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.
The statute also specifies, however, that the term “security-based swap dealer” does not include a person who enters into security-based swaps for their own account “not as a part of a regular business.”
The Commission intends to interpret this definition in a manner that builds on the dealer-trader distinction that already is used to identify dealing activity involving other types of securities, while taking into account the special attributes of security-based swap markets.
De Minimis Exemption from Definition of Security-Based Swap Dealer
The Dodd-Frank Act directs the Commission to exempt a person (who otherwise would be deemed a “security-based swap dealer”) who “engages in a de minimis quantity of security-based swap dealing. . . ” It also directs the Commission to establish factors for determining when someone should be exempt. The proposed rule would require that a person meet all of the following conditions to be exempt from the dealer definition on the basis of de minimis activity:
- The aggregate effective notional amount, measured on a gross basis, of the security-based swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $100 million.
- The aggregate effective notional amount of such security-based swaps with “special entities” (as defined in Exchange Act Section 15F(h)(2)(C) to include certain governmental and other entities) over the prior 12 months must not exceed $25 million.
- The person must not enter into security-based swaps as a dealer with more than 15 counterparties, other than security-based swap dealers, over the prior 12 months.
- The person must not enter into more than 20 security-based swaps as a dealer over the prior 12 months.
Definition of “Major Security-Based Swap Participant”
There are three parts to the definition of “major security-based swap participant” under the Dodd-Frank Act. A person who satisfies any one of them is a major security-based swap participant:
- A person 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 for hedging or mitigating risks in the operation of the plan.
- A person 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.”
- Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major security-based swap categories.
The statutory definition excludes security-based swap dealers.
Definition of “Substantial Position”
The Dodd-Frank Act provides that the Commission should define “substantial position” at a threshold it deems to be “prudent for the effective monitoring, management or oversight of entities that are systemically important or can significantly impact the financial system of the United States.”
The Commission proposes to define “substantial position” using objective numerical criteria which promote the predictable application and enforcement of the requirements governing major participants. The Commission proposes tests that would account 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 (any security-based swap based on instruments of indebtedness, including loans, or on credit events relating to one or more issuers or securities), and other security-based swaps.
- First test of “Substantial Position”
The proposed thresholds for the first test would be a daily average current uncollateralized exposure of $1 billion in the applicable major category of security-based swaps.
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.
- Second test of “Substantial Position”
The second test proposed by the Commission would account for both current uncollateralized exposure (as discussed above) and the potential future exposure associated with a person’s security-based swap positions. The second substantial position test would determine potential future exposure by:
The proposed thresholds for the second test would be $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major security-based swap category.
- 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%.
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 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
The proposed definition of hedging or mitigating commercial risk would not encompass any security-based swap position that is held for a purpose that is in the nature of speculation or trading.
Definition of “Substantial Counterparty Exposure”
The Commission 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”
The third aspect of the statutory definition of major security-based swap participant addresses any “financial entity,” other than one subject to capital requirements established by an appropriate Federal banking agency, that is “highly leveraged” relative to the amount of capital it holds, and that maintains a substantial position in a major category of security-based swaps. For this part of the definition, the Commission proposes to use the same definition of substantial position described above, without excluding hedging or employee benefit plan positions.
For this aspect of the definition, the Commission 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 Commission proposes two possible definitions – 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.
Under the Dodd-Frank Act, the Commission has been engaging in significant rulemaking:
- Security-based swap reporting and dissemination: Proposed new rules entailing how security-based swap transactions should be reported and publicly disseminated.
- Security-based swap data repositories: Proposed new rules that would specify the requirements for security-based swap data repositories.
- Security-based swap fraud: Proposed a new rule to help prevent fraud, manipulation, and deception in connection with the offer, purchase or sale of any security-based swap — as well as in connection with ongoing payments and deliveries under a security-based swap.
- Security-based swap conflicts: Proposed rules intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading.
- Reporting of pre-enactment security-based swaps: Adopted an interim rule that requires certain swaps dealers and other parties to report any security-based swaps entered into prior to the July 21 passage of the Dodd-Frank Act. This rule applies only to such swaps whose terms had not expired as of July 21.
- Strengthening oversight of investment advisers: Proposed new rules to facilitate the registration of advisers to hedge funds and other private funds with the SEC; implement a mandate to require reporting by certain advisers that are otherwise exempt from SEC registration; increase the asset threshold for advisers to register with the SEC; and define "venture capital fund."
- Asset-backed securities: Proposed rules that would enhance ABS disclosure by:
- Requiring registered ABS issuers to perform a review of the assets that underlie the ABS.
- Requiring an ABS issuer to disclose the nature, findings and conclusions of this review of assets.
- Requiring the issuer or underwriter for both registered and unregistered ABS offerings to disclose the findings and conclusions of any review performed by a third party that was hired to conduct such a review.
- Whistleblower: Proposed a whistleblower program and rules that would reward individuals who provide the agency with high-quality tips that lead to successful enforcement actions.
- Say-on-Pay: Proposed rules that would enable shareholders to cast advisory votes on executive compensation and "golden parachute" arrangements.
- Municipal advisor registration: Adopted a temporary rule requiring municipal advisors to register with the SEC.
The proposal seeks public comment and data on a broad range of issues relating to the proposed rules, including the costs and benefits associated with the proposal. After careful review of comments, the SEC and the CFTC will consider whether to adopt the proposed rules or modify them.