By David Surbeck, Reed Smith LLP

In the attached piece, David Surbeck of Reed Smith LLP offers practical insights about the documentation of eligible contract participant (ECP) provisions in the context of single bank loan and syndicated agent lending transactions. 

You may access this article by clicking the following link:

Download file

This article makes reference to recent provisions published by the Loan Syndications & Trading Association ("LSTA") and the International Swaps and Derivatives Association ("ISDA").   

You can access the LSTA provisions, along with a memorandum (dated 15 February 2013) that the LSTA published in respect of these provisions, by clicking here.

You can access the ISDA provisions by going to www.isda.org and searching for "ISDA Keepwell" in the Search box (that is usually located in the upper right hand corner of the screen).  There are two related pieces: 1) the provisions themselves; and 2) a brief memorandum published by ISDA explaining these provisions.  ISDA published this material on April 18, 2013.

Good day.  Good, practical insights. TSR

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The proposed agenda covers:

• Minimum Block Sizes for Swaps;
• The "Made Available to Trade" Rule Under section 2(h)(8) of the Commodity Exchange Act and Swap Transaction Compliance and Implementation Schedule;
• Core Principles for Swap Execution Facilities (SEFs); and
• Anti-disruptive Practices Authority - Interpretive Guidance and Policy Statement.

You can obtain information about participation by clicking here.

Good day. Good agenda. TSR

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 By Andrew Cross, Crystal Travanti and Tom Watterson of Reed Smith LLP

We have prepared the above-referenced guide to the eligible contract participant ("ECP") definition under section 1a(18) of the Commodity Exchange Act ("CEA").  The guide does not cover every aspect of the ECP definition, but rather focuses on the application of the so-called "entity" and "natural person" ECP tests as:

1) Presented in section 1a(18) of the CEA;

2) Implemented by CFTC Rule 1.3(m); and

3) Interpreted and augmented by CFTC Letter 12-17.

It is our hope that this guide clarifies the key aspects of the ECP definition.  Of course, the guide does not constitute legal advice, since any application of the ECP definition must give effect to the unique situations of the counterparties and their swap transaction.

Download file

Good day.  Good guide? TSR

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We are asked this question with ever increasing frequency, so we thought that we would answer it "once and for all".

These are the forms that the question takes:

How do I know if my counterparty is a swap dealer?

How do I know if I am trading with a foreign affiliate of a U.S. swap dealer?

Are there any major swap participants registered with the CFTC right now?

Do you know if there is an "official" list of registered swap dealers and major swap participants?

And, the answers to those questions can be found by clicking the link under each heading below.

Swap Dealers 

Click here for the CFTC's official list of provisionally registered swap dealers (current as of the date listed at that website).

Major Swap Participants

Click here for the CFTC's official list of provisionally registered major swap participants (current as of the date listed at that website)

And, that may result in another question:

What does it mean for a swap dealer or major swap participant to be "provisionally registered"?

It means that the National Futures Association has received a Form 7-R from the SD or MSP.  

Given the "in-progress" status of implementation of the Dodd-Frank Act's changes to the Commodity Exchange Act and related CFTC rules, the entire industry is provisionally registered as of this particular point in time. 

That will change at some point in the future - don't ask when, because we do not know either. 

Good day.  Great questions. TSR

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By Andrew Cross and Crystal Travanti

OVERVIEW

The CFTC recently issued no-action relief from certain swap data reporting requirements for swaps entered into between affiliated counterparties.  The relief is conditioned upon several factors, which we have summarized in greater detail in the table below. 

In general, Letter 13-09 grants relief from: historical swap reporting (Part 46); "regular" swap reporting under Part 45 for swaps entered into on or after April 10, 2013; and reporting requirements under the end-user exception (Part 50).  The following is a list of the specific regulatory reporting requirements for which Letter 13-09 grants relief:

• CFTC Rule 45.3(d)(1) - Primary economic terms data reporting
• CFTC Rule 45.3(d)(3) - Confirmation data reporting
• CFTC Rule 45.4(c)(1)(ii) - Life cycle event and state data reporting
• CFTC Rule 45.4(c)(2)(ii) - Current daily mark valuation reporting
• CFTC Rule 45.5 - Unique swap identifier requirements
• CFTC Rule 46.3(a) - Reporting of historical swaps in existence on or after 4/25/2011
• CFTC Rule 46.3(b) - Reporting of historical swaps expired or terminated prior to 4/25/2011

• CFTC Rule 50.50 - Reporting of swaps for which end-user exception central clearing has been claimed

Additionally, it is important to note that the no-action relief granted for swaps that involve wholly-owned subsidiaries differs from the relief granted for swaps that involve majority-owned subsidiaries. 

Under Letter 13-09, the relief is available where the affiliation arises by virtue of either:

1) A parent-subsidiary relationship between the affiliates; or
2) A brother-sister relationship (i.e., common parent relationship) between the affiliates. 

In either case, the affiliation can be direct or indirect. Finally, the relief granted in Letter 13-09 does not apply to any swaps for which the affiliated counterparties have elected to claim the inter-affiliate exemption from central clearing pursuant to CFTC Rule 50.52.

SUMMARY OF RELIEF GRANTED UNDER LETTER 13-09: PART 45, PART 46 & PART 50 

In this section of the posting, we will provide a more detailed summary of the specific relief granted under Letter 13-09.  To facilitate a "snapshot view" of that letter, we have prepared a table that summarizes the conditions of the relief in respect of the Part 45 and Part 50 reporting requirements listed above - we address Part 46 in the final paragraph that immediately follows the table.

Finally, with respect to Part 46, the CFTC clarified that a reporting counterparty must satisfy the conditions summarized in the first four rows of the table.  Furthermore, any such reporting counterparty must adhere to the recordkeeping requirements of the Part 46 rules.

Good day.  Good relief. TSR

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By Andrew Cross and Tom Watterson, Reed Smith LLP

INTRODUCTION

The CFTC just released (less than 7 hours before the deadline) CFTC Letter No. 13-10 providing no action relief from the reporting requirements of Parts 43, 45, and 46 for non-swap dealer, non-major swap participant counterparties. By our count, there are now nine different reporting deadlines.

As an introductory item, non-swap dealer banks or other financial entities that have reporting obligations (such as hedge funds or insurance companies) should all be aware that the swap reporting requirements for new interest rate swaps and credit swaps begins April 10, 2013.

AN OVERVIEW OF LETTER 13-10

The extent and timing of the relief provided by CFTC Letter 13-10 is a function of several factors:

•  The classification of the counterparty as a financial entity (as defined under Section 2(h)(7)(C)(i)  of the Commodity Exchange Act) 

• The asset class of the swap - foreign exchange*, interest rate, credit, equity  and other commodity - that is subject to the reporting requirement

• The particular type of reporting obligation (Part 43 real time reporting, Part 45 "regular" reporting, Part 46 historical swap reporting)

• The "new" compliance date

* CFTC Letter No. 13-10 uses the term "foreign exchange swaps" (which is a defined term in §1a(25) of the CEA) as one of the asset classes. We assume that this is referring to all "foreign exchange transactions" that fall under the reporting requirements, inclusivie of foreign exchange swaps and foreign exchange forwards that have been excluded from the definition of a "swap" pursuant to the determination by the Secretary of the Treasury. The final rule release for Part 45 uses the term "foreign exchange transactions."

There were also, of course, certain policy reasons offered in support of the relief.  So, put another way, CFTC  Letter 13-10 can be thought of as consisting of answers to the following questions:

Who is the reporting counterparty?

What type of swap is being reported?

Where in the CFTC's rulebook can the particular reporting obligation be found?

When do the reporting obligations become effective under the deferred compliance schedule?

Why was the relief issued?

To help you make sense of it all, we have developed the following - "The Who, What, Where, When and Why" Table for CFTC Letter 13-10.

And, what is the WHY?

The CFTC staff acknowledged that the development of swap data reporting systems has encountered more technological and operational challenges than expected and that reporting compliance has been more difficult for equity swaps, FX swaps, and other commodity swaps. However, the CFTC staff claimed that financial entities (such as non-swap dealer banks) were more likely to have pre-existing technological capability to develop swap reporting systems.

NO RELIEF FROM RECORDKEEPING REQUIREMENTS

CFTC Letter 13-10 did not afford any relief from the recordkeeping requirements under Parts 43, 45 or 46 of the CFTC rules.

And, as a practical item, since Part 45 recordkeeping obligations begin April 10, 2013, non-swap dealer, non-major swap participant counterparties must obtain a CFTC Interim Compliance Identifier by April 10, 2013 (they can do so by going to www.ciciutility.org). 

 AND, FINALLY, WHO IS A FINANCIAL ENTITY?

A "financial entity" has the meaning given to it in Section 2(h)(7)(C)(i) of the Commodity Exchange Act.  By way of non-limiting example, that statutory definition certainly covers banks, insurance companies and hedge funds.  So, it is very clear...for some market participants. 

But, what about a subsidiary of a commercial holding company that manages risk on behalf of the entire commercial, non-financial enterprise by entering into hedging transactions with other non-swap dealers, as well as non-swap dealers? Is that type of "risk management subsidiary" a financial entity or not?  Is its risk management an activity that is "financial in nature under section 4(k) of the Bank Holding Company Act"? How should that type of a risk management subsidiary apply the deadlines in CFTC Letter 13-10?

That question was not addressed by the relief in CFTC Letter 13-10, which can be found here.

Good day. Good delay(s)? TSR

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Please note that this message does not constitute legal advice and, in any event, may not be applicable to your particular situation.  Therefore, you should consult with legal counsel to determine whether: 1)  any of the enumerated items are applicable to you; or 2) if you need to take any additional actions not enumerated on the above list.

Good day.  Good luck. TSR

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A few updates of note:

1) Dodd-Frank Protocol 2.0 Open - As of March 22nd, Dodd-Frank Protocol 2.0 is open for adherence.  More information is available here.

2) Further Guidance Issued by TMPG on Initiative to Margin Forward Agency MBS - On March 27th, the Treasury Market Practices Group of the New York Fed issued additional guidance on its initiative to various delayed delivery trading of agency mortgage-backed securities.  Of note, the TMPG delayed its recommended compliance schedule from early June to year end 2013.  There are also clarifications as to:

a) the type of MBS trading subject to margining (TBAs, ARMs, specified pools, and CMOs); and

b) the forward period that will subject a trade to margining (greater than 3 days for CMOs and greater than 1 day for TBAs, ARMs and specified pools.

The guidance is available here. 

Also, you can read our original article on the TMPG's recommendation here.

3) Swap Reporting - As of now, the swap reporting rules go into effect on April 10th (as if you all did not know).  Although, it is widely expected that there will soon be a barrage of well-reasoned requests from nearly every corner of the market for delays.  We believe that this delay is needed, especially for non-swap dealer market participants, and entirely consistent with existing deferral patterns for other aspects of Title VII implementation.  But, only time will tell.

Good day.  Good endurance. TSR

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Section 2(e) of the Commodity Exchange Act requires every swap counterparty to be an eligible contract participant ("ECP").  In CFTC OGC Letter No. 12-17, the CFTC Office of General Counsel stated that it interprets section 2(e) to require each guarantor of a swap to be an ECP.  In other words, as a general rule, a non-ECP can not guarantee the obligations of a swap counterparty that is an ECP.

This interpretive position should be noted by all banks that offer interest rate swaps to borrowers as hedges, regardless of whether or not the bank is a swap dealer.  And, for obvious reasons, it is also of interest to borrowers.

Inspired by the recent Valentine's Day holiday, we offer our readers the following summary:

In these days post-Dodd-Frank,
It can be hard to be a bank.

Or even a borrower, friends you see,
With a swap that is guaranteed,
By someone other than an ECP.

Good day.  Good poem? TSR

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By Andrew P. Cross and Allison W. Sizemore, Reed Smith LLP

This posting summarizes Advisory Opinion 2013-01A, which was issued by the U.S. Department of Labor in February 2013 in order to address key interpretive issues relating to the ability of pension plans to trade centrally cleared swaps.  This posting will be of interest to pension plans and their asset managers, as well as swap clearinghouses and their futures commission merchant members ("CCPs" and "Clearing Members," respectively, in the language of the Advisory Opinion).

OVERVIEW

In Advisory Opinion 2013-01A, the U.S. Department of Labor ("DOL") concluded that:

(1) A Clearing Member is not a fiduciary under section 3(21)(A)(i) of the Employee Retirement Income Security Act of 1974 (ERISA), solely by virtue of its exercise of account liquidation rights negotiated between the Clearing Member and a plan fiduciary in connection with the documentation required to establish a centrally cleared swap trading account for the plan at the Clearing Member (the "Swap Account Documentation"). 

Significantly, in connection with this conclusion, the DOL opined that margin held by a Clearing Member or the CCP is not a plan asset for purposes of Title I of ERISA - rather, the plan assets are the rights the plan has to receive a payment from the Clearing Member in connection with the exercise of the account liquidation rights under the Swap Account Documentation.

(2) A cleared swap transaction will not constitute a "prohibited transaction" under Section 406 of ERISA, as long as the Swap Account Documentation was entered into by a qualified professional asset manager (or "QPAM") that acted prudently in making its decision to enter into, and negotiating, such documentation and otherwise satisfied the requirements of Prohibited Transaction Exemption (PTE) 84-14 (the QPAM Exemption). 

This conclusion was based, in pertinent part, on the DOL's opinion that a Clearing Member would provide clearing related services to the plan and constitute a "party in interest" under ERISA section 3(14)(B).  It is noteworthy, however, that the DOL did not view the CCP as a party in interest, on the basis that it only provided services to the Clearing Members and the market as a whole, but not directly to the plan.

The DOL's conclusions were made in reliance on the legislative history and policy objectives of the Wall Street Reform and Consumer Protection Act, Title VII of the  Dodd-Frank Act (the "Dodd-Frank Act"), which imposed clearing and trade execution requirements on standardized swaps with the goal of reducing overall risks to the U.S. financial system.  And, as regular readers of The Swap Report may recall, we have on many occasions in the past described the goal and effect of the Title VII reforms as changing the swap markets from a principal-to-principal, contract-based market to customer-to-agent, regulation-based market.  This certainly is the view expressed by, and literal foundation of, the DOL's relief provided to pension plans under Advisory Opinion 2013-01A.

 ERISA Fiduciary Status

The Dodd-Frank Act imposes swap clearing and execution requirements on swap dealers and major swap participants in their transactions with counterparties, which may include ERISA plans.  Pursuant to the Swap Account Documentation, the Clearing Member is given certain rights upon the plan's default, which frequently include the right to liquidate the plan's position, sell assets from a margin account, enter into offsetting transactions, or take other de-risking action to decrease the impact of the plan's default on other market participants and the financial system as a whole (collectively, "Default Rights").

Against this backdrop, a question arises as to whether, by taking control of assets of an account established by an ERISA plan in this manner, the Clearing Member is a plan fiduciary within the meaning of Section 3(21)(A)(i) of ERISA.  That statutory provision defines such a fiduciary as a person who "exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets."

The DOL noted initially that margin deposited by the plan with the Clearing Member of CCP is not a plan asset, so ERISA's trust requirements do not apply to the margin account.  Instead, the plan asset consists of the rights embodied in the Swap Account Documentation, particularly as such rights permit the plan to receive certain payments from the Clearing Member following the member's exercise of Default Rights.  Assuming then that the Swap Account Document ion was negotiated between the Clearing Member and ERISA plan counterparty through an independent fiduciary to the plan, the DOL determined that the mere exercise of contractual default remedies by the Clearing Member does not make it an ERISA fiduciary.

Prohibited Transactions

The next question addressed is whether the CCP or the Clearing Member is a "party in interest" under ERISA (i.e., a party that provides services to the plan) and, if so, whether performing swap clearing related services or exercising contractual rights under the Swap Account Documentation constitute a prohibited transaction.  The DOL concluded that the CCP is not a party in interest because it provides services to the Clearing Member and the central clearing system as a whole, but does not provide services directly to the ERISA plan counterparty.

The Clearing Member, on the other hand, has a direct contractual relationship with the ERISA plan counterparty and provides services in respect of the cleared swaps, including the collection of margin.  Thus, the DOL views the Clearing Member as a party in interest as defined in ERISA § 3(14)(B).  As a party in interest, the Clearing Member would engage in a prohibited transaction by providing swap services to the plan for a fee, unless an exemption applies.  The DOL concluded that most swap contracts between a plan and a Clearing Member are exempt under Prohibited Transaction Exemption 84-14, which provides relief for transactions in which the plan's interest is managed by a qualified professional asset manager ("QPAM").  The relevant portion of Prohibited Transaction Exemption 84-14 is satisfied if the QPAM and the Clearing Member enter into a contract that contains sufficient detail such that default remedies and other subsidiary transactions are reasonably foreseeable to the QPAM upon entering into the Swap Account Documentation.  As a related item, the DOL provided representative examples of provisions affecting account liquidation rights that should be included in the Swap Account Document ion and further stated that:

Under Section 404 of ERISA, a QPAM must act prudently with respect to the decision to enter into [Swap Account Document ion] as well as in negotiating specific terms of the [Swap Account Documentation].  We note that in order to satisfy its responsibilities under section 404, a QPAM may need to request and evaluate additional information beyond what is set forth in the [Swap Account Document ion] regarding liquidation and close-out transactions and pricing methodologies covered by the [Swap Account Documentation], before making a determination to enter in such [Swap Account Documentation].

Thus, on the basis that all of these forgoing conditions and requirements would be satisfied, the DOL concluded that a Clearing Member will not engage in a prohibited transaction with respect to a cleared swap transaction.

Closing Considerations

The DOL's analysis is influenced significantly by:

(1) its interpretation of the Dodd-Frank Act and its legislative history, which indicate that centralized swap clearing is intended to be integral to the stability of the financial system and that applying ERISA's fiduciary requirements to Clearing Members of CCPs would be incompatible with the intent of the Dodd-Frank Act; and

(2) the DOL's assumption and caution that the original decision for an ERISA plan to enter into a cleared swap or related Swap Account Documentation must be undertaken by an independent plan fiduciary. 

The Advisory Opinion provides a significant degree or comfort to Clearing Members and CCPs that the transactions described above, standing alone, will not create a fiduciary obligation or result in a prohibited transaction -- however, a Clearing Member that oversteps or goes beyond the facts described in Advisory Opinion 2013-01A will not be covered by the relief afforded by that opinion.

Good day.  Good opinion. TSR 

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The CFTC is proposing changes to its rules to enhance the protection of customer funds held by Futures Commission Merchants ("FCMs").　 The proposal seeks, among numerous other changes, to amend CFTC Rule 1.25, which governs the permitted investments an FCM may make with customer funds. Under the current Rule 1.25, FCMs must limit reverse repo transactions so that all securities purchased in reverse repo transactions with any one counterparty do not exceed 25% of the FCM’s total assets held in segregation. The proposed rule would provide that, for the purposes of the 25% counterparty calculation, the FCM must aggregate all counterparties under common control.

The CFTC is also proposing an amendment to CFTC Rule 1.29 to make it explicit that an FCM is solely responsible for any losses incurred on investments made pursuant to Rule 1.25.

The Notice of Proposed Rulemaking can be found here. Comments are due by February 15, 2013.

Good day. Good commenting. TSR

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On January 3, 2013, the Office of Comptroller of Currency ("OCC"), Department of Treasury published a notice of guidance to insured Federal depository institutions that are or may become swap dealers (the "Guidance"). As explained below, the effect of the Guidance will be to delay implementation of the so-called "swap push-out" rule from July 16, 2013 to July 16, 2015.

THE SWAP-PUSH OUT RULE AND THE JANUARY 3, 2013 GUIDANCE

Section 716 of the Dodd-Frank Act ("DFA") prohibits the provision of Federal assistance to a Federal depository institution that is a swap dealer or a security-based swap dealer (each such institution, a "Dealer Bank"), unless that Dealer Bank limits its swap activities to those described by the OCC in the Guidance as "conforming swap activities".  In sum, conforming swap activities are those specified in paragraph (d) of Section 716 and include, by way of non-limiting example:

1) Using swaps for hedging or risk mitigation purposes; and

2) Dealing activities that relate to interest-rate swaps, FX swaps,  and cleared credit default swaps.

The effect of Section 716 of the DFA is to require a Dealer Bank to "push out" all of its swap activities that are not conforming swap activities into a separate entity that will not be eligible for Federal assistance (i.e., a "taxpayer bailout," as referred to in the vernacular).  For this reason, Section 716 of the DFA has been called the "swap push-out" rule.

Under the Guidance, a Dealer Bank that does not limit its activities to conforming swap activities will be able to take advantage of a "transition period" and, in essence, defer compliance with Section 716's push-out mandate by two years (from July 16, 2013 to July 16, 2015). 

In order to claim the relief provided by the Guidance, a Dealer Bank should submit a written request to the OCC by January 31, 2013. As an aside, Footnote 10 of the Guidance specifies that, "A [Dealer Bank] whose swap activities are presently limited to conforming swap activities is not eligible for a transition period [i.e., relief from the swap-push out mandate effective July 2013] because it would not be subject to the prohibition on Federal assistance."  In other words, such a bank does not need relief from prohibitions that do not apply to it.

The full text of the Guidance is available here.

Good day. Good delay? (May we never, ever find out anything to the contrary!) TSR

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Good day.  Good list. TSR

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Today, the CFTC deferred the compliance date for many of the Dodd-Frank's external business conduct standards from December 31, 2012 to May 1, 2013.  The press release and related Interim Final Rules ("IFRs") are available here.

The CFTC based the issuance of the IFRs and related compliance date extension, to a large extent, on representations made to the regulator by the International Swaps and Derivatives Association ("ISDA") regarding the lack of preparedness of the vast majority of derivatives market participants to adhere to the ISDA Dodd-Frank Protocol. 

ISDA has represented to the [CFTC that, despite an extensive counterparty outreach and education effort by its members, only 17.5% of counterparties to prospective [Swap Dealers or "SDs"]  and [Major Swap Participants or "MSPs"] have submitted an adherence letter for its first Dodd-Frank protocol and less than 1% have submitted the completed questionnaires necessary for SDs and MSPs to make use of the protocol and integrate necessary counterparty information into their compliance systems.  ISDA has represented that more time is needed for these counterparties to understand the CFTC's requirements, to understand the legal consequences of adhering to the protocol, and to gather the information needed to complete the questionnaire from principals and beneficial owners.

In other words, the implementation state for the Dodd-Frank Protocol may accurately be described as "Ready-Set-WHOA!"  Based upon the IFRs and related preamble issued by the CFTC, it appears that May Day (May 1, 2013) is the "new" New Years Eve (December 31, 2012), at least for for purposes of the Dodd-Frank Protocol adherence deadline. 

As part of the issuance of the IFRs, the CFTC also:

1) Extended the compliance dates for two other rules until July 1, 2013: the Portfolio Reconciliation Rule (Rule 23.502) and the Swap Trading Relationship Documentation Rule (Rule 23.504); and

2) Declined to extend complianace dates for the following business conduct standards applicable to SDs and MSPs:

a) Prohibitions on fraud, manipulation and abusive practices (Rule 23.410(a));

b) Fair dealings in communications (Rule 23.433); and

c) Reasonable diligence regarding recommended swaps (Rule 23.434(a)(1)).

As a result, the compliance date for these three business conduct standards was not affected by the deferral for Dodd-Frank Protocol related business conduct standards.

Good day. Good delay. TSR

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Attention swap market participants interested in learning more about the end-user exception to central clearing - a free webcast recording from 12/4 is available for download at www.securitiesdocket.com.  

Good day. Good downloading. TSR

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On December 4th at 1 p.m., FTI Consulting will host a free Securities Docket webcast on the end-user exception to central clearing. 

PRESENTERS

Erik F. Remmler, Associate Director of the Commodity Futures Trading Commission
Dr. Susan Mangiero, FTI Consulting
Andrew P. Cross, Reed Smith

DATE & TIME

December 4th, 1:00 p.m. Eastern

COST

Nothing - it is free

HOW TO REGISTER

Click here

WHO SHOULD ATTEND

• Banks That Provide Interest Rate Swaps to Commercial Borrowers
• In-House Counsel Who Support Corporate Treasury Functions
• CFOs and Treasurers
• Publicly Traded Corporations That Hedge Risks - Interest Rate, FX, Commodity
• Energy Industry Market Participants
• Internal and External Auditors
• Any Swap Market Participant That Enters Into Swaps For Hedging Purposes or Offers Swaps to Another Participant That Hedges With Those Swaps

WHAT TOPICS WILL BE COVERED

• CFTC Rule 39.6, the "End-User Exception to Central Clearing"
• Who qualifies for the exception
• How to meet the tests that demonstrate that swaps are being used to hedge or mitigate commercial risk
• The role of the board and risk management or audit committees in approving the exception
• What to expect when transacting with a financial entity
• How the end user exception applies to inter-affiliate swaps
• How the end-user exception applies to swaps entered into by a subsidiary that hedges the risks of its "corporate family" (such as a "Treasury subsidiary")

Good day. Good opportunity? TSR

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The press release and determination are available here

More to come in a bit.

Good day. Good reading. TSR

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On November 14th, the CFTC issued a press release announcing a proposal to publish the CFTC Swaps Report, not to be confused with The Swap Report - Reed Smith's blog on derivatives and regulatory transactional issues.

The CFTC Swaps Report is a CFTC transparency initiative to aggregate and publish swaps market data on a weekly basis.  Structurally, the CFTC Swaps Report will consist of a set of tables and supporting documentation covering the following items:

Notional Outstanding - This part of the report will include information about notional amounts outstanding on both a gross and net basis by participant type, cleared status and product type (interest rates, credit, equity and commodities).

Transaction Volume - This part of the report will include information about the total weekly swap transaction ticket volumes by currency, tenor, and grade.

Archive, Data Dictionary, and Explanatory Notes - There will also be background information about the report, including prior weeks' publications.

In addition to this weekly report, market participants will have access to trade information on a more frequent basis as a result of the CFTC's Real-Time Public Reporting of Swap Transaction Data pursuant to Part 43 of the CFTC's Rules. 

You can read all about the proposed CFTC Swaps Report by clicking  here, a hyperlink brought to you courtesy of The Swap Report.

You already know how to find The Swap Report.

Good day.  Good report? TSR

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 Who Should Pay Attention to the end-user exception to central clearing (and, by extension, this posting)?

You should pay attention to this posting if you are any of the following:

1) A swap dealer or major swap participant that intends to offer hedging products to counterparties;

2) A non-swap dealer bank that intends to offer hedging products to borrowers;

3) A commercial end-user that enters into OTC derivatives as part of your corporate hedging and risk management program, as is the case with many derivatives market participants across many different industries, such as the airlines, steel, transportation, automobile, energy, electricity industries, as well as virtually any other other non-financial industry that you can imagine;

4) A company that "consolidates" or "aggregates" its risk management activity within a single subsidiary that, in turn, enters into hedging transactions with a third-party swap counterparty, such as a swap dealer, major swap participant or non-swap dealer bank;

5) A U.S. publicly traded company, since you will have heightened corporate governance requirements to claim the end-user exception; or

5) A financial institution with $10 billion in total assets, since you may be able to qualify as a "small financial institution" and utilize the end-user exception in connection with your hedging activities.

OK, you convinced us - the topic has broad appeal - what is the end user exception to central clearing?

The end-user exception to Dodd-Frank's central clearing and trade execution mandate is by far one of the most significant aspects of Title VII's derivatives market regulatory reforms. 

In short, the exception will enable a qualifying market participant to implement a risk management and hedging program by entering into non-cleared derivatives - or, in other words, to continue hedging the way that it hedged before the enactment and implementation of Dodd-Frank's reforms.  Due to the nature of this exemption, the list of market participants that will be affected is quite long and covers a broad swath of the derivatives market, ranging from banks offering hedges to borrowers or other customers to publicly traded companies using swaps to hedge or mitigate commercial risk. 

A claimant must either not be a "financial entity" - a technical term defined under the rule and related statutory provision.  Or, in the alternate, the claimant may  be a financial entity that meets one of following exceptions enumerated in CFTC Rule 39.6:

1) Be a "captive finance affiliate";

2) Be acting as an "agent of behalf of its affiliates"; or

3) Be a "small financial institution".

All three of these terms are very technical and are defined under the rule. 

Additionally, a U.S. publicly traded company will be required to take additional corporate governance steps that will, in some manner, involve the approval of the company's Board of Directors or a committee of the Board.

Finally, there are reporting requirements under CFTC Rule 39.6 that apply on a trade-by-trade or annual basis. (And, as an aside, there are also reporting requirements under Parts 45 and 46 of the CFTC's rules that apply in the context of inter-affiliate trades or trades between a non-swap dealer bank, even if those trades qualify for the end-user exception from central clearing.)

Wow - that seems like alot of information to digest.  You did not give us specifics.

We recognize that, but believe that awareness is the first step in the process of understanding and, in our experience, many derivatives market participants are not focused on the importance or complexity of the end-user exception. 

In the coming weeks, we expect that there will be many opportunities for market participants to learn more about the end-user exception.  We will certainly keep you apprised of any such events in which we are participating.

In the meantime, and as an introductory matter, we have created a flowchart or "picture" of CFTC Rule 39.6 that synthesizes this complex rule in one-page. You can download this file by clicking here.

Download file

Consider this a "walking map" to the end user exception - if you would like, call it a "tule" or a TOOL THAT MUST BE READ ALONGSIDE THE RULE (get it, "tule," as in tool for the rule). And, as such, we must give you the standard lawyerly disclaimer that this posting is not legal advice. (And, the Editor-in-Chief gives his thanks to Crystal Travanti for help with thinking through the development of the walking map and Tom Watterson for creating that map.  They are true regulatory cartographers!)

This is a very complex topic that must be analyzed, in light of your particular facts and circumstances, with the assistance of qualified counsel.

Good day. Good luck. TSR

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On September 10th, the CFTC staff issued a "Q&A" responding to questions from market participants on the timing of when entities will be required to register as swap dealers.

The "back of the envelope" answer is no earlier than December 31, 2012, if a particular entity's swap dealing exceeded the de minimis threshold during the period from October 12th (the effective date of the CFTC's swap dealer rules) and October 31st of this year. After than, an entity will be required to register no later than two months after the end of the month in which that person becomes no longer able to take advantage of the de minimis exception under the swap dealer rules. Although, the CFTC did clarify that nothing prevents an entity from registering as a swap dealer at anytime after the effectiveness of the swap dealer rules.

The Q&A is available here.

Good day. Good clarification. TSR

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On August 29th, ISDA and FIA published its Form of Addendum for Cleared Derivatives Transactions. As its name suggests, it is an addendum to an agreement - most likely a futures customer account agreement - between a clearing member (most likely, a futures commission merchant or FCM) and the clearing member's customer. The form of agreement is available here.

Good day. Good development (at least in terms of turning the kaleidoscope for many market participants). TSR

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On August 27th, the CFTC decided to defer compliance dates with swap dealer external business conduct standards that involve documentation until January 1, 2013 (See pages 157 and 158 of the adopting release for the "Documentation/Compression" rule, which is available here)

Many of these business conduct standards were driving the Dodd-Frank Protocol and LEI initiatives.

The CFTC's action is likely to provide derivatives market participants with a slight reprieve (from mid-Q4 2012 to beginning Q1 2013) in terms of timing pressures related to compliance with the Dodd-Frank Protocol and obtaining LEIs (or "CICIs" as they are properly called).

Good day. Good  reprieve. TSR

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AUGUST 27TH UPDATE: The CFTC has deferred the application of business conduct standards relating to swap documentation from mid-October to January 1, 2013. See our August 28th posting available here.

To obtain your legal entity identifier, go to this website:

http://www.ciciutility.org

Who needs to obtain an LEI? In other words, why should I care about this?

Every market participant that enters into over-the-counter (OTC) derivatives must have an LEI and, based upon current Dodd-Frank rulemaking from the CFTC, you need to have your LEI by mid-October.

What else do I need to do by mid-October?

If you have an ISDA Master Agreement in place with a party that is likely to register with the CFTC as a "swap dealer," then you also need to decide whether or not you want to continue to trade OTC derivatives under that ISDA. If you do, then you need to adhere to ISDA's Dodd-Frank Protocol by mid-October or, by that time, negotiate provisions on a bi-lateral basis that address the types of issues addressed by the Protocol.

Under the protocol, all market participants will be giving representations and should become familiar with these representations - and taking any internal actions necessary that may be needed to give the representations.

If you are an investment manager, then you will be giving representations to the swap dealers with which your clients have ISDAs in place - even if the client is the principal to the ISDA and executes the document as such. Therefore, you should familiarize yourself with these representations and take any additional steps that may be needed to give the representations.

To learn more about ISDA's Dodd-Frank Protocol, go to this website:

http://www2.isda.org/functional-areas/protocol-management/protocol/8

Good day. Good luck. TSR

AUGUST 27TH UPDATE: The CFTC has deferred the application of business conduct standards relating to swap documentation from mid-October to January 1, 2013. See our August 28th posting available here.

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 One of the hallmarks of the derivatives market regulatory reforms under Title VII of the Dodd-Frank Act is the requirement that standardized swaps be subject to central clearing. Yesterday, the Commodity Futures Trading Commission (CFTC) issued a proposal that, if enacted, will afford market participants - including financial institutions - with relief from the central clearing mandate for qualifying inter-affiliate swaps. The proposed rule is available here.

BACKGROUND: THE RELIEF IS LIKELY TO BE MOST USEFUL TO FINANCIAL ENTITIES

As background, there is an "End-User Exception" to the central clearing mandate. That exception, which is found in CFTC Rule 39.6, includes an exemption for inter-affiliate swaps in the context of non-financial end-users. It is not widely available for financial end-users, such as banks, swap dealers, major swap participants, commodity pools. Yesterday's proposal would afford all end-users - including financial end-users - with relief from the central clearing mandate for qualifying inter-affiliate swaps.

AN OVERVIEW OF THE PROPOSED RULE

A swap will be eligible if it was entered into between majority-owned affiliates, such as a parent and a subsidiary or two wholly owned subsidiaries of the same parent corporation, that have consolidated financial statements. Under the proposal, majority ownership will be based upon ownership of a corporation's voting stock or, in the case of a partnership, capital contributions or rights to capital upon dissolution.

Other requirements will also need to be satisfied, including:

1) The affiliates must share a centralized risk management program;

2) The posting of daily variation margin, if the affiliates are "financial entities," a term that includes banks, swap dealers, major swap participants and commodity pools. There is a narrow exception to the variation margin requirements for wholly-owned, commonly-guaranteed affiliates;

3) Board or committee approvals to utilize the exemption, if the party claiming the exemption issues publicly traded securities (i.e., registered under Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act")) or makes public filings under section 15(g) of the Exchange Act; and

4) On-going position reporting to a swap data repository (SDR) and regulatory reporting to the CFTC.

The release also includes information on the availability of the exemption in circumstances where one of the affiliates is located outside of the U.S.

Comments on the proposal are due 30 days after its publication in the Federal Register.

Good day. Good reading and perhaps commenting. TSR

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Interesting piece today from Silla Brush in Bloomberg Businessweek entitled, "Swap Dealers May Get Until January To Register".  You can access the full article by clicking here.

In sum, there appears to be ambiguity as to whether swap dealers need to register by mid-October 2012 or January 2013, due to the possibility of a "roll in" period that would not apply until the dealer crossed the de minimis swap dealing threshold.

Good day. Good...ness... TSR

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You can access it by clicking here.

Good morning. Good clicking yet again. TSR

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It is official - the "product" rule has been published in the Federal Register. You can access it by clicking here.

Good morning. Good clicking. TSR

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The Time Is At Hand...

If you have not yet started to get serious about getting your company ready for Dodd-Frank's derivatives market regulatory reforms, now is the right time to do so. In sum, your company may need to take several actions over the next few weeks, like dealing with ISDA's Dodd-Frank Documentation Initiative and related Dodd-Frank Protocol or, in the case of public companies using swaps for hedging purposes, getting necessary board approvals to take advantage of the end user exception to Dodd-Frank's central clearing mandate. 

Where to start this process?

Reasonable minds could differ, but one good starting point would be to familiarize yourself with legal entity identifiers or LEIs - what they are, why they are important & where to obtain them. 

Why?

Because many market participants will need to make a decision about adherence to the ISDA Dodd-Frank Protocol by mid-October and one of the first steps of that process is to obtain a legal entity identifier. 

How do I learn more about LEIs?

We anticipated that question - in fact, we planted it right into the posting for purposes of an overall conversational tone to a potentially monotone topic.

Here is some background information from DTCC, one of the service providers designated by the CFTC to implement the initial LEI program in the U.S.

The Legal Entity Identifier (LEI) program is designed to create and apply a single, universal standard identifier to any organization or firm involved in a financial transaction internationally. Such an identifier for each legal entity would allow regulators to conduct more accurate analysis of global, systemically important financial institutions and their transactions with all counterparties across markets, products and regions, allowing regulators to better identify concentrations and emerging risks.

And, for inquiring minds that want to know, the full DTCC write-up is available here.

Good morning. Get ready, get set... TSR

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In this posting, we muse on a simple - YET VERY IMPORTANT - issue: the treatment of a foreign exchange forward (also known as, "currency forward" or  "FX forward") as a "swap" for purposes of the derivative market regulatory reforms embodied in Title VII of the Dodd-Frank Act.

WHY EVERYBODY THAT TRADES FX FORWARDS SHOULD CARE (AND WHY FUNDS AND ADVISERS SHOULD REALLY CARE)

As a threshold matter, if FX forwards are "swaps," then they may become more expensive to trade. The added expense could arise by virtue of the fact that these contracts would be subject to the full panoply of Title VII's reforms, including capital and margin requirements and the now "almost famous" central clearing and trade execution mandates.

Furthermore, if FX forwards are "swaps," then the contracts would fall within the definition of a "commodity interest" under the Commodity Exchange Act ("CEA"). As a consequence, such designation would require heightened analysis of whether or not a particular investment fund or its adviser is acting as a commodity pool operator ("CPO") or commodity trading advisor ("CTA") or, at a minimum, subject to rigorous compliance testing required to be conducted to qualify for exemptions from CPO / CTA analysis.

THE CONVENTIONAL WISDOM: DELIVERABLE FX ARE NOT SWAPS

Based upon our experience, the current thinking on the Street -- the "CW" if you will - is that a deliverable foreign exchange forward is not going to be a swap. As far as we can tell, such thinking is rooted in the definition of a currency forward under Section 1a(24) of the CEA...

[A foreign exchange forward is] a transaction that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.

...coupled with the added facts that:

1) CEA Section 1a(47)(E)(i) authorizes the Secretary of Treasury to issue a written determination under Section 1b of the CEA that FX forwards should not be regulated as swaps;

2) The Secretary of Treasury has, in fact, issued a request for comment on its proposed exemption of FX forwards from the definition of a swap; and

3) In the final "swap definitional" rule - issued in pre-publication form on July 13, 2012 - the CFTC and the SEC (the "Commissions") acknowledged that a "foreign exchange forward," as defined under Section 1a(24) will not be considered to be a "swap," if the Secretary of Treasury issues a written determination to exempt the product from the swap definition.

So, according to the conventional wisdom, the market just needs to wait for that final determination by the Secretary of the Treasury.

BUT, IS THE CONVENTIONAL WISDOM RIGHT?

If you are a regular reader of TSR, then you know that we respect conventional wisdom, although rarely trust it.

In this case, we think there is ambiguity in key guidance from the Secretary of Treasury and the Commissions, especially when read against the language in the statute itself.

In other words, the statute focused on the intention of the parties at the inception of the forward contract, but the Secretary of Treasury and the Commissions suggest that the actual exchange of currencies at settlement is what matters the most. 

And, as explained in our May 6, 2011 posting, "OTC Currency Forward: A Diagnostic View of Offsetting Positions In the Wake of the Treasury's Proposed Determination to Exempt FX Forwards"  (just click the title to go there), this focus is potentially problematic, given that most "deliverable" FX do not actually settle by the physical exchange of currencies. Instead, the parties enter into an offsetting deliverable position to close-out the trade with one party making a net payment in a single currency that it owes to the other party.

While it may be that both Treasury and the Commissions are referring to a situation in which the confirmation of a deliverable FX transaction - that is a "foreign exchange forward" - is amended subsequent to the inception of the contract, so as to restructure the trade as a non-deliverable forward or NDF. But, that is not entirely clear based upon a plain English reading of the above-cited language.

Finally, in closing, it is worth noting that in the context of a physical commodity forward, the CFTC focuses on the terms of the contract, rather than what happens at settlement of that contract - (hint: look at the treatment of so-called  "book outs" of a physical commodity forward, if you are interested) .  In other words, there is precedent for taking the position that the terms of the contract, rather than the settlement mechanisms matter. While it is quite possible that the conventional wisdom is right after all....we think that the final swap definition release has further muddied the analysis for market participants.

But, perhaps all hope is not lost, since the Treasury and the Commissions may be willing to clarify this point, by way of example, in response to a comment letter from interested market participants.

Good day. Good ambiguity? TSR

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In a July 6th article, Silla Brush of Bloomberg Businessweek reported that, "The CFTC is poised to exempt banks wiith assets of $10 billion or less" from Dodd-Frank's central clearing mandate. The full article is available here.

During the comment period on the proposed rule related to the central clearing mandate, financial institutions and related industry groups - including trade groups for mid-market lenders - advocated that a higher asset threshold of $30 or even $50 billion be used for purposes of this exemption. As a general matter, a higher threshold will result in fewer banks being subject to mandatory central clearing. The banks and industry groups that have advocated for a higher thresholder have expressed the view that the exemption would afford relatively smaller financial institutions with increased flexibility in respect of their risk management programs.

The CFTC is scheduled to vote on central clearing related rules on Tuesday, July 10th.  

Good day. Good waiting. TSR

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Background: The Statute, The Rule

Section 1a(49)(A) of the Commodity Exchange Act contains the statutory definition of the term "swap dealer" and excludes an insured depository institute ("IDI") "to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer."

CFTC Rule 1.3(ggg)(5) implements 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. 

Throughout the remainder of this posting, we will often refer to rule as the "loan origination rule". Structurally, the rule has three components:

1) The "In Connection With" Prong - The swap must relate to the loan itself or, in the technical language of the statute and rule, "be entered into in connection with originating a loan with that customer";

2) The "Loan Origination" Prong - The IDI must have originated the loan or, put slightly differently, have actually liability for the provision of the cash to the borrower; and

3) The "Anti-Evasion" Prong - The exclusion can not be used in a manner that evades the requirements of the swap dealer regulations generally.

This posting explores each of the components of the loan origination rule and related interpretive material from the related Adopting Release, which was published in the Federal Register on May 23, 2012 (77 Fed Reg 30596).

Before turning to each prong, we will answer three threshold questions of primary importance...

WHAT IS A LOAN? WHAT IS AN INSURED DEPOSITORY INSTITUTION? WHAT IS AN OFFER? & WHAT HAPPENS IF THE IDI TRANSFERS OR TERMINATES THE LOAN OR THE SWAP?

First, let's focus on the meaning of the term "loan" under the CFTC's loan origination rule. Rather than provide a specific definition in the rule, the CFTC opted to refer to the meaning of the term under common law, explaining:

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. 77 Fed Reg 30622

Second, let's focus on the meaning of insured depository institution. For purposes of the loan origination rule, the term "insured depository institution" has the meaning given to it in the Federal Deposit Insurance Act. Nothing more, nothing less.

Third, let's focus on the idea of an offer, since the loan origination rule excludes an IDI from the definition of a swap dealer if it "offers" to enter into a swap with a customer in connection with originating a loan with that customer." In the Adopting Release, the CFTC reiterated its view 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." 77 Fed Reg at 30623

So, knitting these together, we could say that:

A loan is a loan by any other name;

An IDI is only an IDI if it is one by name; and

An offer does not really even need to be an offer, regardless of what you call it.

With due respect and a nod to Sir William for the paraphrase.

Finally, let's focus on the effect of a transfer or a termination of the loan to which the swap relates, since this question has already come up several times over the past month from several FoTSRs (Friends of The Swap Report).. Here, the CFTC's words are better than anything that we could ever say:

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. 77 Fed Reg at 30623

On the other hand, if the IDI were to transfer the swap (but not the loan) to another IDI, and the IDI that is the transferee of the swap is not a source of money to the borrower under the loan, then the transferee IDI would not be able to apply the exclusion to the swap. Footnote 335, 77 Fed Reg 30623.

THE "IN CONNECTION WITH" PRONG

Clause (i) of CFTC Rule 1.3(ggg) sets out the conditions that must be satisfied, in order for a swap to qualify as having been "entered into in connection with originating a loan with that customer". The table that follows summarizes each condition alongside any related interpretive guidance provided by the CFTC in the Adopting Release. At the outset please note that the first column of the table is a title for each requirement that we have assigned for purposes of presentation; no such title exists in the actual text of the rule.

 THE "LOAN ORIGINATION" PRONG

Clause (ii) of CFTC Rule 1.3(ggg) specifies when an IDI will satisfy the requirement that it originated a loan with the particular customer. In short, the exclusion is available to all IDIs that are a source of a transfer of money to a borrower pursuant to a loan. To this end, the loan origination rule provides that an IDI will satisfy the loan origination requirement if it:

1) Directly transfers the money to the borrower;

2) Is part of a lending syndicate that is the source of the funds transferred to the borrower;

3) Is an assignee of the loan, obtains a participation in the loan, or purchases the loan.

In the Adopting Release, the CFTC makes clear that, "[I]f an IDI were to transfer its participation in a loan to a non-IDI, then the non-IDI would not be able to claim this exclusion, regardless of the terms of the loan or the manner of the transfer. Similarly, a non-IDI that is part of a loan syndicate with IDIs would not be able to claim the exclusion." Footnote 328, 77 Fed Reg at 30623.

THE "ANTI-EVASION" PRONG

Finally, in order to prevent evasion of the swap dealer regulatory requirements generally, Clause (iii) of Rule 1.3(ggg)(5) provides that the statutory exclusion does not apply where:

1) The purpose of the swap is not linked to the financial terms of the loan;

2) The IDI enters into a "sham" loan; or

3) The purported "loan" is actually a synthetic loan such as a loan credit default swap or a loan total return swap (commonly called a loan CDS or a loan TRS, respectively).

In other words, these requirements amount to the "anti-evasion" prong of the loan origination exclusion under CEA §1a(49(A) and CFTC Rule 1.3(ggg)(5).

Good day. Good exclusion. TSR

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The following are selections from CFTC Chairman Gensler's June 19th testimony before the U.S. House Financial Services Committee. The complete text of Chairman Gensler's testimony is available here.

We believe the comments are worth repeating in their near entirety, as they provide a roadmap to the coming CFTC rule proposal on the topic of the cross-border application of Dodd-Frank's derivatives market regulatory reforms. If you don't have time to read them in their entirety, these are the highlights:

Section 722(d) of the Dodd-Frank Act states that swaps reforms shall not apply to activities outside the United States unless those activities have “a direct and significant connection with activities in, or effect on, commerce of the United States.”

  ...if a legal entity has over $8 billion in U.S. swap dealing activity, it should be preparing to register as a swap dealer. For foreign financial institutions, swaps with U.S. persons or their overseas branches would count toward the de minimis threshold. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk posed to a branch from being transmitted to its parent bank.

We recommend that you take a few minutes to read these comments in their entirety.

Cross-border Application of Dodd-Frank’s Swaps Reforms

Recent events at JPMorgan Chase are a stark reminder of how trades executed by traders located overseas can quickly reverberate with losses coming back into the United States.

Section 722(d) of the Dodd-Frank Act states that swaps reforms shall not apply to activities outside the United States unless those activities have “a direct and significant connection with activities in, or effect on, commerce of the United States.”

The CFTC plans to soon put out to public comment our interpretation and related guidance on this provision to get public feedback.

The nature of modern finance is that financial institutions set up hundreds, if not thousands of legal entities around the globe. During a default or crisis, risk of overseas branches and affiliates inevitably flows back into the United States.

****

Balanced implementation of regulatory reform requires an acknowledgment that the activities of financial institutions engaging in transactions or setting up operations abroad can pose a profound threat to U.S. taxpayers and the economy.

As the JPMorgan Chase CIO trades were executed by traders located abroad, I would like to provide for the Committee a description of the CFTC staff recommendation that has been before Commissioners.

First, it provides the guidance that when a foreign entity transacts in more than a de minimis level of U.S. swap dealing activity, the entity would register under the Dodd-Frank Act swap dealer registration requirements.

Second, it includes a tiered approach for overseas swap dealer requirements. This is largely consistent with comments received from major international swap dealers. Some requirements would be considered entity-level, such as for capital, risk management, recordkeeping and reporting to SDRs. Some requirements would be considered transaction-level, such as clearing, margin, real-time public reporting, trade execution and sales practices.

Third, entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could meet these requirements by complying with comparable and comprehensive foreign regulatory requirements, or what we call “substituted compliance.”

Fourth, transaction-level requirements would apply to all U.S. facing transactions. For these requirements, U.S. facing transactions would include not only transactions with persons or entities operating or incorporated in the United States, but also transactions with their overseas branches. Likewise, this would include transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity’s swap activity.

Fifth, for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank transaction-level requirements may not apply. For example, this would be the case for a transaction between a foreign swap dealer and a foreign insurance company not guaranteed by a U.S. person.

This means if a legal entity has over $8 billion in U.S. swap dealing activity, it should be preparing to register as a swap dealer. For foreign financial institutions, swaps with U.S. persons or their overseas branches would count toward the de minimis threshold. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk posed to a branch from being transmitted to its parent bank.

As a swap dealer, the entity would have to comply with the various Dodd-Frank provisions applicable to swap dealers, though in certain cases, this may be done through substituted compliance.

In addition to the interpretive guidance, the CFTC also is considering a release on phased compliance for foreign swap dealers. The separate release addresses comments from U.S. and international market participants. For overseas swap dealers, the staff recommendation provides for phased compliance in the following manner:

• Foreign swap dealers would be required to register with the CFTC upon the compliance date of the registration requirement;

• Compliance with transaction-level requirements with U.S. persons and branches of U.S. persons would be required;

• Entity-level requirements (other than reporting to SDRs) that might come under substituted compliance may be delayed for up to one year. During that time, the CFTC would be moving to complete the cross-border interpretive guidance and would work with market participants and foreign regulators on plans for substituted compliance; and

• For overseas swap dealers, swap transactions with U.S. persons and branches of U.S. persons would be required to be reported to a SDR (or the CFTC).

Good day. Good preview of the proposal. TSR

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On June 6th, the U.S. Commodity Futures Trading Commission announced the filing of a Federal enforcement action against Atlantic Bullion & Coin, Inc. and Ronnie Gene Wilson (the "Defendants"). The press release is available here. 

The enforcement action relates to a Ponzi scheme and, in that regard, is the quintessential subject matter for a regulatory enforcement action. From that perspective, the action does not appear to be out-of-the-ordinary. But, on closer inspection, the enforcement action is noteworthy for two reasons:

1) The action relates to CFTC Rule 180.1, the anti-fraud and market manipulation rule promulgated by the CFTC under authority given to it under Dodd-Frank reforms; and

2) The CFTC alleges that the Defendants "fraudulently offered contracts of sale of silver bullion ("silver"), a commodity in interstate commerce".

What makes these two reasons "noteworthy"? Great question and glad that you asked it...

In these post-Dodd-Frank days, many market participants focus almost exclusively on the jurisdiction of the CFTC over derivatives, such as futures and swaps. But, this enforcement action stands as a stark reminder that the regulatory jurisdiction of the CFTC covers spot transactions in physical commodities, in addition to derivatives transactions. Commodity traders of all stripes must keep this fact in mind in designing their post-Dodd Frank compliance programs, given that the fountainhead of this particular enforcement action is CFTC Rule 180.1, the new Dodd-Frank anti-manipulation rule. 

Good day. Good reminder. TSR

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Something to ponder on...

Assume that you are a buyside entity and you are facing a financial institution failure that could bring down a swap dealer / FCM.

Now, ask yourself this question...

From a counterparty credit risk perspective, which of the two do you prefer in this post-MF Global, post-Dodd Frank world?

OTC look-a-like based upon an exchange-traded futures contract with daily cash settlement.

If centrally cleared, then subject to Complete Legal Segregation.

If not centrally cleared, then assume that initial margin is held at 3rd party custodian.

OR

Exchange-traded futures contract with initial margin posted with FCM.

Good day. Good pondering. TSR

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On  May 10th, the CFTC voted to propose an order that would extend the effective date of the bulk of the Title VII derivatives market reforms until 31 December 2012.  The press release is available here.

A very helpful and interesting draft rulemaking schedule was also released today. That schedule is available here.

Helpful because...well...it is. Interesting because...

The "Products Definition" (i.e., What is a swap?) appears to be scheduled for June 2012.

The "Harmonization Proposal" (i.e., harmonization of mutual fund disclosures under new Rule 4.5 registration requirements) is due out in August 2012.

Good day. Good delay - but why not more? TSR

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Overview

On April 18^th, the Commodity Futures Trading Commission adopted CFTC Rule 1.3(ggg) and the Securities and Exchange Commission adopted Exchange Act Rule 3a71-1, to define the terms “swap dealer” and “security-based swap dealer,” respectively. Each rule is predicated upon a four-prong statutory definition, pursuant to which a market participant will be a dealer in swaps or security-based swaps ("SBS") if it:

1)      Holds itself out as a dealer;

2)      Makes a market;

3)      Regularly enters into swaps or SBS with counterparties as an ordinary course of business for its own account; or

4)      Engages in any activity that causes itself to be commonly known in the trade as a dealer or market maker.

The adopting release in respect of the final rules has not yet been published in the Federal Register, although it has been issued by the CFTC and the SEC. Therefore, as an introductory matter, all information in this posting is subject to change upon publication of the final rule.

In this posting, we synthesize the recently published guidance and present a step-by-step process to assist a market participant with the application of the final swap dealer definitional rules to its swap related activities.

In summary, there are four steps to the process, as follows:

Step 1: Inventory & Exclude Certain Activities

Step 2: Determine the Level of Swap and SBS Related Activities

Step 3: Determine Whether Those Activities Are “Part of a Regular Business”

Step 4: Determine Whether Those Activities Constitute Swap Dealing.

While we hope that this guiding process will be useful, it must be emphasized that this material is for informational purposes only and does not contact legal advice.  Particularly, every market participant should consult with its own legal counsel about the appropriate application of the swap dealer definitional rules to the facts and circumstances of that participant’s business.

Step 1: Inventory & Exclude Certain Activities

A market participant can begin its swap dealer analysis by inventorying its swap and SBS related activities and isolating the excluded activities from those activities that may be covered by the swap dealer definition.

CFTC Rule 1.3(ggg)(5) and (6) excludes the following swaps from the swap dealer determination:

1)      Swaps entered into by an insured depository institution with a customer in connection with originating a loan with that customer;

2)      Swaps entered into with majority-owned affiliates;

3)      Swaps entered into for hedging physical positions;

4)      Swaps entered into by registered floor traders; and

5)      Swaps entered into by a cooperative with its members.

Because of the nature of these excluded activities, the SEC did not adopt a parallel exclusion in respect of security-based swaps with one exception: Exchange Act Rule 3. 3a71-1(d) excludes SBS entered into with majority-owned affiliates from the SBS dealer determination.

Each of these excluded activities will be the subject of subsequent postings in this multi-part series.

Step 2: Determine Level of Swap and Security-Based Swap Related Activities

As the second step, a market participant can look at its non-excluded swap and SBS related activities and make a determination as to whether or not it is a dealer based on the level of those activities.

CFTC Rule 1.3(ggg)(4) allows a market participant to engage in a de minimis amount of swap dealing activities. The rule defines a de minimis amount as $3 billion notional over the prior 12 months, although this level will be $8 billion for an initial three-year phase-in period after the effective date of the rule. In the case of a special entity (ERISA plan, state or municipal funds, etc.), the de minimis level is $25 million over the prior 12 months. For the first year following the effective date of the (not yet finalized) rules implementing the definition of “swap,” the de minimis analysis will only address activity after that effective date.

Exchange Act Rule 3a71-2 contains a de minimis exemption for security-based swap dealing activities.  For credit default swaps, the notional level is set at $3 billion over the prior 12 months, although this level will be $8 billion for an initial nine month phase-in period after the effective date of the rule.  For other types of security-based swaps, the de minimis level of dealing activity is substantially lower at $150 million in notional value over the prior 12 months, although this level will be $400 million for an initial nine month phase-in period after the effective date of the rule.  .  In the case of a special entity (ERISA plan, state or municipal funds, etc.), the de minimis level is $25 million over the prior 12 months.

If, in the aggregate, the market participant’s swap and SBS related activities exceed any of these de minimis levels, then the participant should conduct a more nuanced analysis of whether those activities constitute dealing activities.

The de minimis tests will be the subject of subsequent postings in this multi-part series.

Step 3: Determine Whether Those Swap Related Activities Are Part of a Regular Business

The statutory definitions of a “swap dealer” and SBS dealer, as well as the related rules, rules exclude swap and SBS activities that are not part of a regular business. In the adopting release for the swap definitional rule, the CFTC provided additional guidance as to the types and levels of activities that constitute having “a regular business” of entering into swaps. In particular, the CFTC indicated that any one of the following activities constitutes entering into swaps as part of a regular business:

1.       Outward Focus – A market participant enters 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);

2.       P&L Center – A market participant maintains a separate profit and loss statement reflecting the results of swap activity or treating swap activity as a separate profit center; or

3.       Staffing for Swap Business – A market participant allocates staff and resources to dealer-type activities with counterparties, including activities relating to credit analysis, customer on-boarding, document negotiation, confirmation generation, requests for novations and amendments, exposure monitoring and collateral calls, covenant monitoring, and reconciliation. In respect of this activity, the CFTC specifically noted that, “[T]his element of the definition should be applied in a reasonable manner, taking all appropriate circumstances into account.

In the absence of any of these factors, it may be possible for a market participant to determine that its swap related activities are not “part of a regular business” of entering into swaps and, by extension, that it is not a swap dealer. Of course, any such determination would be made in light of the facts and circumstances of the participant’s business.

The SEC echoed similar factors in the adopting release, although focused its analysis on the “dealer-trader distinction” discussed in greater detail under Making a Market in Step 4 of this guide.

Step 4: Determine Whether Its Swap Related Activities Constitute Swap Dealing

If entering into swaps or SBS appears to be part of a regular business, then a market participant is likely to be a dealer under the “ordinary course of business” element of the swap dealer and SBS dealer definitions. As noted earlier, a market participant will be considered to be a dealer if it regularly enters into swaps or SBS with counterparties as an ordinary course of business for its own account.  A participant enters into a swap or SBS for “its own account” when it enters into a swap or SBS as a principal, and not as an agent (the latter also, however, being a regulated activity, although not necessarily as a swap dealer or SBS dealer).

In addition to the “ordinary course of business” element, a market participant’s swap related activities will constitute dealing if it falls into any one of the following categories of activity.

Holding Itself Out or Engaging in Dealing Activities – The participant holds itself out as a dealer in swaps or engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. Although these are two separate prongs of the swap dealer definition, the CFTC and SEC indicated that the following factors are indicia of swap dealing and SBS dealing activity under either prong.

a.       Contacting potential counterparties to solicit interest;

b.      Developing new types of swaps or SBS and informing potential counterparties of their availability and of the participant’s willingness to enter into the swap or SBS;

c.       Membership in a swap association (e.g., ISDA) in a category reserved for dealers;

d.      Providing marketing materials describing the types of swaps or SBS the party is willing to enter into; and

e.      Generally expressing a willingness to offer or provide a range of products or services that include swaps or SBS.

Making A Market In Swaps or SBS – The participant “makes a market” or routinely stands ready to enter into swaps at the request or demand of a counterparty, regardless of whether the counterparty and the market maker engage in bilateral negotiations or anonymously through an exchange. without regard to whether or not the counterparty’s identity is known. Although it offered no objective guidance as to what constitutes “routinely,” the CFTC did indicate that the term “means that a person must do so more frequently than occasionally,” although not necessarily on a continuous basis. The CFTC and SEC indicated that the following activities, when routinely entered into, are indicia of making a market in swaps:

a.    Quoting bid or offer prices, rates or other financial terms for swaps or SBS on an exchange;

b.    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 or SBS;

c.     Placing limit orders for swaps or SBS; or

d.    Receiving compensation for acting in a market maker capacity on an organized exchange or trading system for swaps or SBS.

To further assist with the market making determination, these four factors should be analyzed against the backdrop of what is referred to as the “dealer-trader” distinction. Generally, under this distinction, a trader seeks to profit from changes in the value of a swap or SBS, while a dealer seeks to profit by providing liquidity to the market. Accordingly, the sources of dealer compensation are i) the provision of liquidity to the markets; ii) spreads or fees, broadly interpreted to cover profits between two or more swaps or a swap and another financial instrument like a futures contract or iii) unrelated to changes in the value of the swaps or SBS that it enters into.

In closing, it should be noted that the four prongs are applied independently of one another. So, by way of example, a market participant may be making a market in swaps, but not necessarily holding itself out as a swap dealer.

Good day. Good luck. TSR

A Step-by-Step Process For Applying The Definitional Rules

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We are delighted to announce an upcoming multi-part series of postings that relate to the final rules for the definitions of swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, and eligible contract participant. Structurally, this series will consist of 22 postings, organized as follows:

So, check back often over the next few weeks, as new postings will appear every few days.

Good day. Good checking back. TSR

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On Friday, March 30th, the Federal Reserve Board, the OCC and the FDIC clarified that the effective date of the Swap Push Out Provision - Section 716 of the Dodd-Frank Act - is July 16, 2013.

The press release and official guidance are available here.

And, for the record, we first asserted this in July 2010 - although, admittedly, we asserted July 15, 2013, instead of July 16, 2013 (which I still say was not bad given everything that was going on back in the glorious summer of 2010. Don't believe me? You can look at our July 2010 Title VII Teleseminar summary available here - and, before somebody says it, NO - we did not plant the answer that we wanted in that summary! If we were going to do that, we would have change July 15 to July 16. Unless, of course, we wanted to give you the appearance of having nailed it...Don't even think it - I am joking!

Let's be honest: the real point of this posting is not our July 2010 Teleseminar summary...it is the March 30, 2012 position of the bank regualtors...and, admittedly, they could have gone either way 2012 or 2013, depending upon their view of whether "Act" meant DFA or Title VII.

Good day. Good clarification. TSR

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21 February: CFTC pulled the swap dealer / MSP definitional rule from its agenda for the 23rd February meeting.

Revised itinerary is available here.

Good day. Good luck keeping up with everything. TSR

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Long Title, Short Posting

CFTC meeting will be held on February 23rd at 9:30 a.m. EST. You can get more information including dial-in, webcast, etc. from the CFTC by clicking here.

Good day. Good news about that swap dealer definitional rule (at least the uncertainty will be over). TSR

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NEW RULES WILL AFFECT ALL MONEY MANAGEMENT INDUSTRY PARTICIPANTS

On February 9th, the CFTC issued final amendments to Part 4 of its rules that will impose additional compliance obligations on nearly every category of money management industry participant, including:

• Investment advisers regulated by the Securities and Exchange Commission ("SEC");
• Mutual funds and exchange-traded funds registered under the Investment Company Act of 1940 (the "1940 Act");
• Hedge funds that are exempt from registration under the 1940 Act; and
• Commodity trading advisors (CTAs) and commodity pool operators (CPOs) subject to the exclusive jurisdiction of the CFTC, including CPOs of exchange-traded vehicles that invest in commodity derivatives ("Commodity ETVs").

SUMMARY OF THE AMENDMENTS AND THEIR EFFECT ON INDUSTRY PARTICIPANTS

There are six primary amendments, as summarized below. The amended rules will become effective 60 days after their publication in the Federal Register (which, as of the date of this posting, has not yet happened) with the exception of the new reporting requirements for CPOs and CTAs under CFTC Rule 4.27, which will become effective on July 2, 2012. Although, as noted in the following summaries, there are staggered compliance dates for these rule amendments.

1) MODIFICATION TO RULE 4.5 EXCLUSION FOR MUTUAL FUNDS 

The amended rules modify the criteria that must be satisfied in order for a mutual fund's investment adviser to claim relief under CFTC Rule 4.5 from regulation and registration as a "commodity pool operator". Specifically, the amended rule will impose restrictions on the use of derivatives by a mutual fund for non-hedging purposes and marketing of the fund as a vehicle for investing in derivative.

In connection with this amendment, the CFTC has proposed a rule (the "Harmonization Proposal") that, if adopted, will harmonize certain compliance and disclosure obligations for mutual funds operated by a CPO that will be subject to registration requirements under the amended CFTC Rule 4.5.

Compliance Dates - The CFTC has proposed staggered compliance dates for registration and other compliance obligations.

• CPO registration will be required by the later of December 31, 2012 or 60 days after the effective date of the final rulemaking further defining the term "swap," as will be published by the CFTC in the Federal Register at a future date.
• Entities required to register due to the amendments to Rule 4.5 will be required to comply with the CFTC's recordkeeping, reporting, and disclosure requirements within 60 days from the effectiveness of the final rule implementing the Harmonization Proposal.

2) RESCISSION OF "SOPHISTICATED INVESTOR" EXEMPTION FOR HEDGE FUNDS

The amended rules rescind an exemption from CPO registration that is widely utilized by hedge fund industry participants. In particular, the CFTC has rescinded CFTC Rule 4.13(a)(4) for operators of pools that are offered only to individuals and entities that satisfy the qualified eligible person standard in CFTC Rule 4.7 or the accredited investors standard under the SEC's Regulation D. This exemption is often referred to as the "sophisticated person" exemption.

Of note, the CFTC has not eliminated the "de minimis" or "limited trading" exemption available to hedge funds under CFTC Rule 4.13(a)(3).

Compliance Dates - The rescission will take effect on December 31, 2012 for CPO's claiming an exemption under CFTC Rule 4.13(a)(4) or, for all other CPOs, 60 days after publication of the rescission of the sophisticated investor exemption in the Federal Register.

3) NEW REPORTING REQUIREMENTS FOR CTAs and CPOs, INCLUDING COMMODITY ETVs

Amended CFTC Rule 4.27 will require CTAs and CPOs that are pooled investment vehicles other than 1940 Act registered investment companies or hedge funds, including Commodity ETVs, to report information and data to the CFTC on Forms CTA-PR and CPO-PQR, respectively. The CFTC indicated that its intention in adopting these reporting requirements was to make data collection requirements that apply to CPOs and CTAs subject to their exclusive regulatory jurisdiction consistent with data collection required under the Dodd-Frank for entities registered with both the SEC and the CFTC.

Compliance Dates - Compliance dates, as summarized in the rule's adopting release, vary by size of assets under management:

• September 15, 2012 for a CPO with $5 billion or more of assets under management attributable to commodity pools as of the last day of the firscal quarter most recently completed prior to September 15, 2012; and
• December 15, 2012 for all other registered CPOs and CTAs.

4) NEW SWAP DISCLOSURE REQUIREMENTS FOR CPOs AND CTAs

The final rule amendments mandate new risk disclosures for CPOs and CTAs regarding swap transactions.

Compliance Date - These additional risk disclosure statements will be required for all new disclosure documents and all updates filed after the effective date of this final rulemaking.

5) ANNUAL FILING OF EXEMPTIVE RELIEF NOTICES BY ALL INDUSTRY PARTICIPANTS

The amendments to Part 4 require annual notice filings to claim exemptive relief under any number of CFTC rules. These notice filings will be based upon a calendar-year end filing date, rather than the anniversary of the original filing.

Compliance Date - December 31, 2012

6) RESCISSION OF CFTC RULE 4.7(b)(3) RELIEF FROM CERTIFICATION REQUIREMENT

The rule amendments will rescind relief from the certification requirement for annual reports provided to operators of certain pools offered only to qualified eligible persons under CFTC Rule 4.7(b)(3).

Compliance Date - December 31, 2012

MORE TO COME, SO STAY TUNED

In the coming days, TSR will provide an in-depth, practical analysis of each of these new rule amendments and their effect on different industry participants. So, stay tuned - there is more to come. 

Good day. Good summary? TSR 

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Ok. Click here  for the rule - hot off the e-presses...

Good day. Good digesting. TSR

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Here at TSR, we do not usually do "free-form thinking" posts - rather, we try to focus on concrete regulatory and transactional issues related to derivatives. But, today is an exception....

In plowing through the Volcker Rule(s), the plethora of Title VII's reforms, what seems like a daily list of potential unintended consequences, Enhanced Prudential Standards, such as Single Counterparty Limits, etc., one can not help but feel that liquidity in the broadest sense of the word and across asset classes will almost certainly be affected.

Increased or decreased?
To what extent and in what asset classes?
What effect on prices in the derivatives markets vs. corresponding long markets? What relationships between those markets?

We have traded the uncertainty of interconnectedness of institutional balance sheets for the uncertainty of regulation. As we are prone to do at TSR, we have attempted to reduce the conceptual into the tabular.

A picture of a few dozen words, we hope, is worth a thousand thoughts. Yours are welcome

Good day. Good pondering. TSR

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On a monthly basis, the CFTC publishes financial data for every registered FCM based upon the reports filed by that FCM. The reports, while brief, contain useful information, such as:

1) The capital requirement for the FCM and available adjusted net capital;

2) The excess capital held by the FCM;

3) The total amount of funds that the FCM needs to segregate on behalf of its customers who are trading U.S. futures contracts; and

4) The total amount of funds that the FCM needs to segregate on behalf of its customers who are trading foreign futures contracts.

And, when the central clearing mandate is implemented, there will certainly be additional information available about the segregated accounts in respect of OTC cleared swaps.

Some market participants find this data (although usually around one month old) to be a useful due diligence and counterparty risk management tool. Historical reports are also available. As we move ever closer to the looming central clearing mandate, this information may be valuable to you or your organization.

Click here to view these reports. You can even subscribe to e-mail alerts when the reports are update.

Good day. Good due diligence. TSR

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When: January 11th @ 9:30 a.m. EST (4:30 p.m. SAST if you are in Cape Town, South Africa, where I might add it appears to be 68 degrees Fahrenheit at the present moment...not too bad for January 12th...but then again, it is SUMMER there and 20 degrees Fahrenheit where I frigidly sit typing)

What: The CFTC will hold meeting to consider:

1) CFTC's proposed Volcker Rule;

2) Final Rule: Registration of Swap Dealers (SDs) and Major Swap Participants (MSPs)

3) Final Rule: Cleared Swaps Customer Contracts and Collateral (Conforming Amendments to Part 190 Commodity Broker Bankruptcy Rules); and

4) Final Rule: Business Conduct Standards for SDs and MSPs with Counterparties.

The CFTC will also consider an order that would delegate authority for SD/MSP registration functions to the NFA.

Details regarding participation are available here.

Good day. Good year. TSR

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http://dealbook.nytimes.com/2011/11/01/cme-investigating-mf-global/

Fellow Customer Risk

(Errr...that was stike through the word "fellow"....err...)

Good day. NOT good reading. TSR

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Good day. Good reading. TSR

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Andrew Cross recently wrote an article that was published in Derivatives Week and Derivatives Intelligence http://www.derivativesintelligence.com  on the topic of documentation. Access to both publications is restricted to paid subscribers or individuals who are granted a free trial subscription.

Good day. Good reading. TSR

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On September 12th, Andrew Cross provided the International Securities Association for Institutional Trade Communication or ISITC - www.isitc.org - with an overview of what derivatives trade flow is likely to look like after Title VII's reforms are implemented. 

The slides for that presentation are available here and contain several helpful diagrams of OTC and exchange-traded derivatives trade flow before and after Dodd-Frank. Additionally, the slides provide an overview of the "Life of a Trade In Regulatory Terms," essentially re-packaging the 2010-2011 CFTC and SEC rulemaking activity into the four primary components of typical (former) OTC derivative trade flow:

 1) Pre-Trade: Parties enter into written documentation to establish an OTC derivative trading and/or clearing relationship. One or both parties may be subject to business conduct standards established by a regulator (i.e., CFTC, SEC).

2) Execution: The parties to an OTC derivative transaction will enter into an OTC derivative trade either directly or through one or more agents (i.e., investment adviser or even an executed broker). Once a trade is executed, it must be given-up to a party that is known as a clearing member of a clearing house.

3) Clearing: A central counterparty steps into the trade and guarantees the performance obligations of the parties that executed the OTC derivative transaction. Frequently, it is said that the CCP becomes the buyer to the seller and the seller to the buyer.

4) Recordkeeping/Reporting: One or both parties to the transaction may have recordkeeping and reporting obligations under applicable law.

In short, the desired effect of Title VII and the related rulemaking activity is to transform the architecture of the (former) OTC markets from an unregulated, principal-to-principal contract-based model to a Federally regulated, intermediary-to-customer regulation-based model. Here is the tabular version of that statement for our readers who are not lawyers.

Logically, changes to architecture will mean changes to trade flow and changes to trade flow mean changes to the documentation of trades and trading relationships (including credit support arrangements).

More to come about that documentation thing later...we promise...

In the meantime,  - did you hear about the draft bill floating around Congress to consolidate the CFTC and the SEC into a united regulatory agency called the Department of Derivatives Documentation or DODD. That was a joke, get it, DODD as in Dodd-Frank...oh forget it. It's Monday.

Good day. Bad joke. TSR

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Letter available here

Text of CFTC Press Release

CFTC’s Division of Market Oversight Provides Temporary Relief from Large Swaps Trader Reporting for Physical Commodities

Washington, DC – The Commodity Futures Trading Commission’s (Commission’s) Division of Market Oversight (Division) today issued a letter providing temporary relief from the requirements of the Commission’s regulations regarding large trader reporting of physical commodity swaps (§§20.3 and 20.4). Because this is the first time that swaps data is being collected, this temporary relief is intended to provide sufficient time to enable both the industry and the Commission to develop and refine systems and processes that will be able to report these complex transactions.

On July 22, 2011, the Commission published large trader reporting rules for physical commodity swaps and swaptions. The rules require daily reports from clearing organizations, clearing members and swap dealers, and become effective on September 20, 2011. The letter issued today provides temporary relief from reporting, as long as parties are making a good faith attempt to comply with the reporting requirements, until November 21, 2011, for cleared swaps, and January 20, 2012, for uncleared swaps. Upon the conclusion of applicable relief periods, such reporting parties must become fully compliant.

Last Updated: September 16, 2011

Good day. Good relief. TSR

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The list is available here - Let us save you the click.

Good day. Good no clicking. TSR

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Chris Kentouris of Securities Technology Monitor recently authored an article entitled, "" available here. The article will provide you with a good, high-level summary of the status of the development of certain key issues in the OTC clearing discussion in the U.S.:

1) The mechanics of customer collateral segregation by a futures commission merchant / clearinghouse in the context of OTC centrally cleared trades; and

2) What will happen to customer collateral, if its swap dealer FCM files for bankruptcy.

Although he article is written from the perspective of the investment management segment of the buy-side, it is good reading for anybody interested in the general issue of segregation of customer collateral, as the issue is developing in the U.S.

Good day. Good reading. TSR

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In light of...

1) The potential for FX forwards and swaps to be given a pass from the definition of "swap" by Treasury; AND

2)  The heightened business conduct standards, in general, that are bound to relate to FX transactions on the heels of the Treasury exemption...

One has to wonder whether or not the various "FX Masters"- think International Foreign Exchange Master Agreement or IFEMA -will become more widely used in the ensuing days, months, years (as appropriate) - no worries, something tells me that there is time to get yourself up to speed with that sort of documentation architecture.

Oh yes and very important...FX Masters NOT to be confused with the Dutch Masters - think either Rembrandt or the $1 cigars sold in the United States since 1911. You pick - it's Friday.

Good day. Good picking. TSR

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 At the petition of the Business Roundtable and the U.S. Chamber of Commerce, the United States Court of Appeals for the District of Columbia Circuit issued a decision dated July 22, 2011 (available here) that vacated a rule promulgated by the Securities and Exchange Commission (the "SEC"). The court issued its decision in response to the petitioner's argument that the SEC "promulgated the rule in violation of the Administrative Procedure Act, 5 U.S.C. § 551 et seq., because, among other reasons, the Commission failed adequately to consider the rule’s effect upon efficiency, competition, and capital formation, as required by" applicable laws. 

Although the particular rule in question does not relate to derivatives regulatory reform, we thought that many of you would be fascinated by this development.

The following are quotations from the court's decision (authored by Circuit Judge Ginsburg) - we believe that these are self-explanatory.

The Business Roundtable and the Chamber of Commerce of the United States, each of which has corporate members that issue publicly traded securities, petition for review of Exchange Act Rule 14a-11. The rule requires public companies to provide shareholders with information about, and their ability to vote for, shareholder-nominated candidates for the board of directors. The petitioners argue the Securities and Exchange Commission promulgated the rule in violation of the Administrative Procedure Act, 5 U.S.C. § 551 et seq., because, among other reasons, the Commission failed adequately to consider the rule’s effect upon efficiency, competition, and capital formation, as required by Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940, codified at 15 U.S.C. §§ 78c(f) and 80a-2(c), respectively. For these reasons and more, we grant the petition for review and vacate the rule. (pp. 2 and 3 of the .pdf version of the decision). 

 We agree with the petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again — as it did most recently in American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167–68 (D.C. Cir. 2010), and before that in Chamber of Commerce, 412 F.3d at 136 — adequately to assess the economic effects of a new rule. Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters. For these and other reasons, its decision to apply the rule to investment companies was also arbitrary.  (p. 7 of the .pdf version of the decision)

Good day. Good reading. TSR 

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From June 24 to July 11. So, comments to Prudential Regulators due on same day as comments to CFTC. Now that just makes sense, right...

Good day. Good procrastinating! TSR

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Last week, the Futures Industry Association and ISDA published a Cleared Derivatives Execution Agreement. As explained by FIA and ISDA, the Agreement is intended to be "a template for use by cleared swaps market participants in negotiating execution related agreements with counterparties to swaps that are intended to be cleared."  The Agreement is available here and FIA and ISDA have prepared a memorandum that summarizes the Agreement. In a conference call this morning sponsored by FIA and ISDA, a panel with representatives from buy-side, dealer and a law firm did an excellent job of summarizing this Agreement.  This posting offers some thoughts about the Agreement.

BACKGROUND: EXECUTION ONLY, VOLUNTARY,  W-I-P & SWAPS ONLY

There are four key background items.

First, as you may recall from either training sessions that we have conducted for friends and clients and/or previous TSR postings - OTC centrally-cleared derivative trade flow can be divided into four components:

1) Pre-Trade: Parties enter into written documentation to establish an OTC derivative trading and/or clearing relationship. One or both parties may be subject to business conduct standards established by a regulator (i.e., CFTC, SEC).

2) Execution: The parties to an OTC derivative transaction will enter into an OTC derivative trade either directly or through one or more agents (i.e., investment adviser or even an executed broker). Once a trade is executed, it must be given-up to a party that is known as a clearing member of a clearing house.

3) Clearing: A central counterparty steps into the trade and guarantees the performance obligations of the parties that executed the OTC derivative transaction. Frequently, it is said that the CCP becomes the buyer to the seller and the seller to the buyer.

4) Recordkeeping/Reporting: One or both parties to the transaction may have recordkeeping and reporting obligations under applicable law.

The FIA - ISDA Cleared Derivatives Execution Agreement will apply to the execution phase, which the Agreement further subdivides into into steps:

i) processing of the trade;

ii) submission and acceptance of the trade into central clearing; and

iii) failure to successfully submit trade to central clearing.

In this regard, it is similar in concept to the template give-up agreement that the FIA has developed for use with respect to exchange-traded futures contracts.

Second, the use of the Agreement is entirely voluntary and is a template. The parties can negotiate additional provisions and/or amendments required to reflect their trading relationship.

Third, the Agreement is intended to be used with swaps, but not security-based swaps.

Fourth,  the CFTC rules in this area (including those that relate to swap execution facilities and swap trading documentation are not yet final). So, this template Agreement is a work-in-progress that will in all likelihood need to be revised.

A PICTURE IS WORTH A THOUSAND WORDS (THEIR WORDS, OUR PICTURE)

The memorandum prepared by FIA and ISDA summarizes the Agreement, so there is no need to do what has already been done (and, given the sources, done quite well). Here is how their summary looks through our eyes (with proper acknowledgment that our view has been influenced by the excellent panel presentation made available by FIA and ISDA earlier today):

A PICTURE IS WORTH A THOUSAND WORDS (OUR WORDS, THEIR PICTURES)

Finally, we note that FIA and ISDA have prepared diagrams of trade flow in the context of an exchange-traded futures contract, on the one hand, and various OTC centrally cleared scenarios on the other. Available here and VERY helpful material. These are some of the best basics out there when it comes to diagram of trade flow of OTC centrally cleared swaps

Good day. Good reading. TSR.

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Not derivatives, but may be of interest to some of you...here are the details. You can register by sending an e-mail to Eric Berkowitz eberkowitz@reedsmith or calling Eric at 412-288-8741.

Among the many legislative outcomes of the Dodd-Frank Act, the creation of the new Consumer Financial Protection Bureau (CFPB) has the potential to be the most disruptive to the institutions covered under its mandate. Slated for official launch on July 22, 2011, the CFPB will affect both bank and non-bank financial services providers and require, at the very least, a reconsideration of a number of compliance issues. Join Reed Smith on Thursday, June 23rd at 12 p.m. (EST) as we begin to demystify the CFPB's likely impact on the financial services landscape.

Our diverse panel includes Mark Oesterle, former Chief Counsel to the Minority of the U.S. Senate Committee on Banking, Housing and Urban Affairs, where he was intricately involved in virtually every aspect of Dodd-Frank, and other Reed Smith attorneys, including Michael Bleier, Roberta Torian, Robert Jaworski and Travis Nelson. The team will focus on the issues facing financial institutions under the CFPB, including:

• What Happens on July 22nd - a review of the new requirements that will require compliance on July 22, 2011, and what covered firms must do to comply.
• Key Issues - a discussion of how the CFPB will impact: 
  • Supervision
  • New Disclosures 
  • Preemption
  • Enforcement

Good day. Good registering. TSR

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In an earlier posting - available here  , we reported that the SEC issued several No Action Letters that have the combined effect of permitting registered investment companies to posting initial margin on cleared swaps directly with their clearing member. By their terms, the no-action relief provided by these letters expires on July 16, 2011.

Q1:Why?
A1:Because on that date, the central clearing mandate in Section 2(h) of the Commodity Exchange Act will become effective and - presumably - Rule 17f-6 will cover the posting of initial margin.

Q2: The CFTC and the SEC just this week delayed implementation of that mandate. So, what will happen to mutual funds that are relying on those no-action letters come July 16th?
A2: Our best guess is that the No-Action Relief will need to be extended.

Q3: Will 17f-6 cover centrally cleared swaps once the Dodd-Frank mandates are effective?
A3: Not as currently drafted, since it only affords relief from Section 17's margin requirements for exchange traded futures and options on futures.

Q4: So, Rule 17f-6 needs to be amended. Are you aware of any proposals to do that?
A4: No. But, we would expect to see them during 2011 (unless the Dodd-Frank mandates are further down the road than this year).

Hey, maybe the presence or absence of 17f-6 No-Action Relief for Dodd-Frank cleared swaps is a "Back of the Envelope" test for just how close implementation really is. Or, maybe there is absolutely no connection whatsoever between the two???? 

P.S. dated 6/17: This last paragraph was only a joke. In seriousness, any proposal to amend Rule 17f-6 would probably be premature, since many of the key concepts the SEC would have to consider in order to revise Rule 17f-6 are the subject to a CFTC proposal dated June 9, 2011 (Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions).

Good day. Good pondering. TSR

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The CFTC has issued a Notice of Proposed Order (Effective Date for Swap Regulation; discussed in posting from earlier today).

Here is a summary of that Proposed Order - comments will be due 14 days after publication in the Fed Reg. Please note that the Proposed Order has not yet been published in the Federal Register and, therefore, is subject to revision.

When used in the chart below, "Title VII" refers only to those portions of Title VII of the Dodd-Frank Act over which the CFTC has been given regulatory authority.

The CFTC's Q&A on the proposed order is available here. The CFTC's Fact Sheet in respect of the proposed order is available here.

Good day. Good reading. TSR.

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Too numerous times to count, it is very true we must say -
Have friends and clients asked us, "What happened yesterday?" 

No more poetry - just the facts.

Provisions That Require A Rulemaking Will Not Be Effective Until The Rules Have Been Finalized

As explained by CFTC General Counsel Berkovitz, "Section 754 of Dodd-Frank provides that, unless otherwise provided, provisions of the Act that require a rulemaking are effective no sooner than the earlier of 60 days after the rulemaking is completed, or 360 days after enactment, which is July 16, 2011. "  (Speech available here). Only a few rules have been finalized (for example, an interim recordkeeping and reporting rule and a retail FX rule that was in the works long before the enactment of Title VII in July 2010), so nothing new all that new to report on that front. These types of  provisions were NOT the subject of yesterday's meeting, although it is worth noting that there is some uncertainty in the market as to whether or not any particular provision in Dodd-Frank requires rulemaking.

Provisions That Do Not Require Rulemaking Go Into Effect On July 16th, 2011

Per yesterday's meeting, the CFTC will be proposing an order that will deal with these provisions. There will be a 14-day comment letter on this order, so that the relief can be provided by July 16th. Doing math that even a lawyer can do, that means that this proposed relief will be forthcoming over next day or two.

Here is our summary of the meeting yesterday in this regard.

 So, that's it for now...at least until the proposed order is released...which we are certain will be soon.

Good day. Good reading. TSR.

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A: Dial into the CFTC's June 14th Open Meeting to consider effective dates of provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act - information is available here. Also, ISDA will be hosting a seminar on the topic on June 15th in New York.

Good day. Good clicking. TSR

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In a June 2nd speech to the National Association of Corporate Treasurers, CFTC Chairman Gary Gensler summarized how transparency fits into the "life of a trade" (And for those of you who have sat through one of our Dodd-Frank training sessions, this will  really resonate!)

Here is our summary of his summary:

 And, just in case you doubt us, here are the actual comments from Chairman Gensler:

The Dodd-Frank Act brings transparency in each of the three phases of a transaction.

First, it brings transparency to the time immediately before the transaction is completed, which is called pre-trade transparency. This is done by requiring standardized swaps – those that are cleared, made available for trading and not blocks – between or amongst financial entities to be traded on exchanges or swap execution facilities (SEFs), which are a new type of swaps trading platform created by the Dodd-Frank Act.

Exchanges and SEFs will allow investors, hedgers and speculators to meet in a transparent, open and competitive central market. Even if you, as corporate treasurers of nonfinancial entities, decide not to use exchanges or SEFs for your swaps transactions – because the Dodd-Frank Act says that you are not required to do so – you still will benefit from the transparent pricing and liquidity that such trading venues provide.

The Dodd-Frank Act mandates that all market participants have the ability to utilize SEFs and derivatives exchanges if they choose to do so. The statute requires these trading facilities “to provide market participants with impartial access to the market.” The CFTC’s proposed rules require SEFs to allow market participants to leave executable bids or offers that can be seen by the entire marketplace. That means that any market participant – a bank or a nonbank – a corporation or a financial institution – can choose if they want to hedge a risk and enter into a swap. This brings competition to the marketplace that improves pricing and lowers risk.

Corporate treasurers will benefit from markets that have competition. When you use the swaps markets, you are paying for a service to reduce your risk. You want a lot of people competing for that business. You want them to compete in a transparent marketplace where you will benefit from better pricing.

Second, the Dodd-Frank Act brings real-time transparency to the pricing immediately after a swaps transaction takes place. This post-trade transparency provides all end-users and market participants with important pricing information as they consider their investments and whether to lower their risk through similar transactions.

The CFTC’s proposed real-time reporting rules include provisions to protect the confidentiality of market participants. The rules also provide for a time delay for large swap transactions – or block trades.

Third, the Dodd-Frank Act brings transparency to swaps over the lifetime of the contracts. If the contract is cleared, the clearinghouse will be required to publicly disclose the pricing of the swap. If the contract is bilateral, swap dealers will be required to share mid-market pricing with their counterparties. Thus, you as corporate treasurers and the broader public will benefit from knowing the valuations of outstanding swaps on a daily basis.

Additionally, the Dodd-Frank Act brings transparency of the swaps markets to regulators through swap data repositories. The Act includes robust recordkeeping and reporting requirements for all swaps transactions so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.

Good day. Good reading. TSR.

Phase of Trade  How DFA Promotes Transparency

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THE STASH CRASH: THE MAY 3RD SWAP REPORT POSTING

As you may recall, in a May 3rd posting (WSJ Reports "Sudden Silver Plunge Erases Rally), I made the following observations:

I am very curious to see what economists have to say about the plunge and whether it was connected to the increased margin requirements...

Yet more factors for the regulators to keep in mind when thinking about phased implementation of the Dodd-Frank's clearing mandates, since new - and higher - margin and capital requirements are "part and parcel" of the new regulatory regime.The purpose of these requirements is simple - ensure that dealers and traders put away more assets in support of their obligations under over-the-counter derivative contracts.

If it does bear out that the squirreling away of assets in the form of margin and capital does cause prices to fall and volatility to rise in certain asset classes, we suggest this phenomenon be referred to as the "Stash Crash".

NO MARGIN FOR ERROR: A MAY 9TH POSTING FROM STREETWISEPROFESSOR.COM

Earlier this week, Dr. Craig Pirrong,  an economist from the University of Houston, posted some comments on the silver Stash Crash (admittedly without using that term) at www.streetwiseprofessor.com - his posting "No Margin For Error" is available here.

Here are some excerpts - and we encourage all of you to read Dr. Pirrong's posting in its entirety:

The CME’s head of clearing, Kim Taylor, vigorously defended the CME's margin increases in silver, (and would presumably make the same defense of today’s moves) [referring to the CME's increased margin on oil and other energy contracts].  Kim’s justification characterizes the clearinghouse’s move as a response to changed market conditions...

....This is sensible, in a way that I’ll explain in a moment, and the way that CCPs usually act.  Taylor tries to emphasize that the changes are predictable, and in some respects they are, but this is not sufficient to relieve CME of the charge that margin changes can cause market movements.

The changes that CME made, and which Kim explains, are sensible in a microprudential sense.  They help ensure that the CME has a sufficient buffer to absorb defaults by traders.  CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.

But the implicit assumption here is there isn’t feedback between margins and prices. [Footnote omitted]  Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”).  That is the essence of a microprudential approach.  That assumption, however, is quite tenuous, and almost certainly untrue.  This is particularly the case for big margin changes during unsettled market conditions.

That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers.  Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.

The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions.  Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves.  That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.

This is why CCP policies that are prudent in some sense can be macroprudentially dangerous.  Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets.  When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically. [EMPHASIS ADDED BY TSR]

As said on May 3rd, we repeat again today...Yet more factors for the regulators to keep in mind when thinking about implementation of the Dodd-Frank's clearing mandates.

Good day. Good reading. TSR.

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On May 2nd, we posted a summary (available here) of the Treasury's proposed determination (available here) to exempt foreign exchange swaps and foreign exchange forwards from the definition of the term "swap" under the Commodity Exchange Act. In this posting, we would like to provide some additional thoughts about the following statement that we made in the May 2nd posting:

[T]o qualify from the central clearing exemption, every FX Forward will need to settle by an actual exchange of currencies on Settlement Date, if the proposed interpretation is read literally. 

We continue to believe that our statement represents a plain English reading of what is in the Treasury Department's proposed determination and interpretation of the term "FX Forward," as defined by the Dodd-Frank Act.  And that is the topic of this posting. But, first, an overview - this is a bit longer than recent postings, so we want you to have a guide.

AN OVERVIEW OF THIS POSTING

1) As an introductory matter, we will review the statutory definition of foreign exchange forward and the Treasury's recent proposed interpretation.

2) We will  examine the structure of a hypothetical OTC currency forward from A) a  transactional perspective and B) a documentation perspective - the hypothetical involves the use of currency forwards by a mutual fund. In particular, the fund will enter into a deliverable currency forward with a bank and, prior to the physical settlement of the contract, enter into an offsetting trade with the same bank- the effect is that a net payment in a single currency is made by the

3) Finally, we will offer our thoughts on what we believe is the appropriate analysis of the hypothetical transactions.

Thus, explaining our not-so-creative, and not-so-brief title to this posting: OTC Currency Forward: A Diagnostic View of Offsetting Positions In the Wake of the Treasury's Proposed Determination to Exempt FX Forwards.

FOREIGN EXCHANGE FORWARD: THE STATUTORY DEFINITION

Section 1a(24) of the Commodity Exchange Act (as amended by Section 720(a)(12) of the Dodd-Frank Act) defines the term "foreign exchange forward" to mean,

a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.

FOREIGN EXCHANGE FORWARD: TREASURY'S STATUTORY RIGHT TO EXEMPT

Section 1a(47) of the CEA (as amended by Section 720(a)(21) of DFA) defines the term "Swap" and in subparagraph (E) authorizes the Secretary of the Treasury, in pertinent part, to exempt foreign exchange forwards from regulation as swaps with the exception of trade reporting and business conduct standards under Section 4r and 4s(h), respectively, of DFA.

Section 1b of the CEA (as added by Section 722(h) of DFA) requires the the Secretary of the Treasury to consider the following 5 factors in making the determination to exempt foreign exchange forwards:

1) Whether the imposition of the central clearing and trading mandates of DFA  would create systemic risk, lower transparency or threaten the financial stability of the United States;

2) Whether foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by DFA for other types of OTC derivatives;

3) The extent to which bank regulators provide adequate supervision of participants in the FX market;

4) The extent of adequate payment and settlement systems; and

5) The use of a potential exemption of foreign exchange forwards to evade otherwise applicable regulatory requirements.

THE PROPOSED DETERMINATION TO EXEMPT FX FORWARDS

The Treasury Department  has issued a proposed determination (Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 75 FR 25774) to exempt foreign exchange forwards from the definition of swaps and, by extension, the central clearing and trading mandates of the DFA.

In issuing its proposed determination, Treasury specifically stated that, "Foreign exchange options, currency swaps, and [non-deliverable forwards or NDFs] may not be exempted from the CEA's definition of "swap" because they do not satisfy the statutory definitions of a foreign exchange swap or forward" (75 FR at25776). Among the factors cited by Treasury in support of its determination is the fact that foreign exchange forwards, "involve the actual exchange of the principal amounts of the two currencies exchanged and are settled on a physical basis" (75 FR at 25777). Treasury did not offer a definition of an NDF.

The following is a tabular summary of the Treasury's analysis of the 5 factors that it must consider under Section 1b of the CEA, in order to make such a determination.

Having laid the groundwork of the "law," let's now turn our attention to the transactional and documentation underpinnings of two hypothetical transactions.

OTC CURRENCY FORWARDS: A TRANSACTIONAL VIEW

Here is our hypothetical: The principal investment strategy of Z-Best Bond Fund, an SEC registered investment company (the "Fund"), is to provide its shareholders with exposure to a diversified portfolio of  U.S. dollar and non-U.S. dollar denominated fixed income investments. As such, exposure to different currencies is a key aspect of the Fund's investment strategy and its investment manager,  Z-Best Adviser (the "Adviser"), takes the relative value of portfolio currencies into consideration when making portfolio investment decisions. The Adviser uses securities, currencies and derivatives to implement its investment views. 

The Adviser anticipates that the USD will strengthen relative to to the Canadian Dollar (CAD) over the next two months. So, consistent with the Fund's investment strategy, the Adviser (on behalf of the Fund) enters into an OTC currency forward with a bank that routinely makes markets in FX products, including OTC currency derivatives. The following are the terms of the forward:

Trade Date: May 6th
Amount and Currency Payable by Fund:100,000 CAD
Amount and Currency Payable by Bank: 102,000 USD
Settlement Date: June 30, 2011

The Fund and the Bank confirm the terms of this forward via an exchange of messages in an electronic trading platform.

Now, fast forward a few weeks...the exact opposite of what the Adviser expected to happened has happened- the USD has weakened relative to the CAD. By mid-June, the Adviser decides to unwind the position, since it believes that further weakening is likely to ensue between now and the Settlement Date. To unwind the trade, the Adviser enters into the following offsetting trade (on behalf of the Fund) with the same bank:

Trade Date: June 15th
Amount and Currency Payable by Fund: 107,000 USD
Amount and Currency Payable by Bank: 100,000 CAD 
Settlement Date: June 30, 2011

Like their original trade, the Fund and the Bank confirm the terms of this currency forward via an exchange of messages in an electronic trading platform.

SO, WHAT HAPPENS ON JUNE 30TH?

The two CAD legs offset one another and the Fund pays the dealer 5,000 USD. In other words, the two currencies are not exchanged. And, now the BIG QUESTION:

We will share our thoughts in a bit...first, however, we would like to provide you with a missing piece of the puzzle: the documentation that makes all of this possible. 

OTC CURRENCY FORWARDS: A DOCUMENTATION VIEW

In our hypothetical, the Fund and the Bank have executed an ISDA Master Agreement (the "Master Agreement") utilizing the 1992, Multiple-Currency, Mutiple-Jurisdiction form of agreement published by the International Swaps and Derivatives Association or ISDA. The Schedule to that Master Agreement includes a provision that specifically states that:

The 1998 FX and Currency Option Definitions as published by the International Swaps and Derivatives Association, the Emerging Markets Traders Association, and the Foreign Exchange Committee (the "1998 FX Definitions") are hereby incorporated in their entirety and shall apply to any FX Transaction or Currency Option Transaction as defined in Section 1.12 and Section 1.5, respectively, of Article 1 of the 1998 FX Definitions. Each FX Transaction and Currency Option (as defined in the 1998 FX Definitions) entered into between the parties shall be governed by the terms of and form part of this Master Agreement. 

Section 1.12 of the 1998 FX and Currency Option Definitions defines an "FX Transaction" as a "transaction providing for the purchase of an agreed amount in one currency by one party to such transaction in exchange for the sale by it of an agreed amount in another currency to the other party to such transaction." Additionally,Section 1.7 of the 1998 FX Definitions provides that, "Unless the parties otherwise specify, Deliverable will be deemed to apply to [an FX Transaction]" and, as used in the 1998 FX Definitions, "Deliverable" means that,  on the Settlement Date, each party will pay the amount specified as payable by it in the related Confirmation (defined under Section 9(e)(ii) of the Master Agreement to include any exchange of electronic messages in an electronic trading platform).

Additionally, the parties have elected to net regularly scheduled payments in the same currency that they owe to one another on the same day, even if those payment obligations arise under different Transactions entered into under the Master Agreement.  (i.e., Since this is a 1992 ISDA, the parties have elected that Section 2(c)(ii) of the Master Agreement does not apply; they could have accomplished this result under a 2002 ISDA Master by specifying that "Multiple Transaction Payment Netting" does apply...but we digress...) 

As a result of this netting election, under the terms of our two hypothetical currency forwards, on June 30, 2011, the USD legs of the two forwards offset one another and the Fund owes the Bank 5,000 (which represents the amount of USD owed by the Fund to the Bank under the June 15th forward less the amount of USD owed by the Bank to the Fund under the May 6th forward).

TREATMENT OF THE TRANSACTIONS  UNDER THE TREASURY'S PROPOSED EXEMPTION?

Let us start by saying, Answers are the easy part; questions raise the doubt. (Jimmy Buffett from "Off to See the Lizard" 1989 from album of same title. Full lyrics available here - they are good.)

Well, what is the answer????? It depends (a lawyer's favorite words!).

Based upon plain reading of the statute, each transaction, standing alone, appears to qualify for the exemption: 

each transaction solely involves the exchange of 2 different currencies (USD:CAD) on a specific future date (June 30, 2011) at a fixed rate that is agreed upon on the3 inception of the contract.

There is simply NO requirement in the statutory language that prevents the offset of exposures - i.e., the CAD legs in our hypothetical transactions - that results from the use of the widely accepted the payment netting mechanisms of the ISDA Master Agreement. Indeed, such payment mechanisms share a common objective as the PVP settlement systems: the elimination of settlement risk.  

Further, analyzing the transactions through the lens of Treasury's own analysis of the five factors (see the table above) produces a similar conclusion with one exception: a precondition of Treasury's analysis appears to be that qualifying foreign exchange forwards, "involve the actual exchange of the principal amounts of the two currencies exchanged and are settled on a physical basis" (75 FR at 25777). And, as noted, non-deliverable forwards - a term that is used, but not defined in the proposed determination - do not qualify for the exemption.

Is an NDF any forward that does NOT involve the actual exchange of principal amounts or is there some way to reconcile the application of the exemption to a trade and its offsetting trade, such as the two transactions used in our hypothetical?  

Yes, we believe that there is: multiple foreign exchange forward transactions that are "Deliverable" transactions, as that term is defined under the 1998 Definitions, should qualify as "foreign exchange forwards," even if the payment netting mechanisms of Section 2 of the ISDA Master Agreement are utilized as a substitute for the actual, physical exchange of currencies between the two parties to the trade. The basis for this is simple: the contracts do solely involve the exchange of 2 currencies - in satisfaction of the statutory definition and requirements of the statute.

Does anybody else think that a comment letter is in order?

Good weekend. Good reading. TSR

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The Treasury's proposed determination to exempt FX Forwards and Swaps was published today in the Federal Register - available here.

Comments due June 6th.

Good day. Good reading. TSR

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Page C2 of today's WSJ contains an article entitled, "Sudden Silver Plunge Erases Rally."In summary, the primary exchange on which silver futures contracts trade and (at least one large) futures commission merchant raised the margin requirements on these contracts. According to the article, the increase for speculative traders equaled about 24% of the margin requirements a week earlier.

"Two weeks of gains in the silver market were erased in 11 minutes as investors sought to avoid higher trading costs and cash out of a historic rally," reports Tattyana Shumsky in the opening paragraph of the article (emphasis added). The article notes that trading volumes were low, since Asian and European markets were closed. Nevertheless, I am very curious to see what economists have to say about the plunge and whether it was connected to the increased margin requirements. (One can't help to think, as Ms. Shumsky reports, that there is an obvious connection between increased trading costs, price declines and volatility.  

Yet more factors for the regulators to keep in mind when thinking about phased implementation of the Dodd-Frank's clearing mandates, since new - and higher - margin and capital requirements are "part and parcel" of the new regulatory regime.The purpose of these requirements is simple - ensure that dealers and traders put away more assets in support of their obligations under over-the-counter derivative contracts.

If it does bear out that the squirreling away of assets in the form of margin and capital does cause prices to fall and volatility to rise in certain asset classes, we suggest this phenomenon be referred to as the "Stash Crash".

Good day. Good reading. TSR

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On April 29th, the U.S. Department of Treasury released a proposed determination that would exempt both foreign exchange swaps (FX Swaps) and foreign exchange forwards (FX Forwards) from the definition of  the term "swap" under the Commodity Exchange Act. The effect of this exemption will be to remove these instruments from the central clearing and trading mandates of the Dodd-Frank Act. Other key aspects of the Act's reforms - such as, reporting to central repository and business conduct standards - will apply to FX Swaps and FX Forwards

THE SCOPE OF THE EXEMPTION

The proposed exemption applies to FX Swaps and FX Forwards, as those terms are defined - narrowly defined, in fact - under Title VII.

FX Swap: A transaction that involves (A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange and (B) a reverse exchange of those two currencies at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.

FX  Forward: A transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.

This means that the following transactions will not be exempt from the definition of a swap and, by extension, the central clearing and trading mandates of the Dodd-Frank Act:

• OTC currency options
• Currency swaps that are not within the definition of an FX swap; and

• Non-deliverable Forwards (NDFs) and other currency forwards that are not within the definition of  an FX forward.

OUR INTERPRETATION OF THIS KEY CONCEPT: (Updated 5/5/2011) Absent clarification through the comment period and issuance of a final interpretation, the actions of the parties on the Settlement Date, rather than the terms of the contract on Trade Date, could be viewed as disqualifying an otherwise eligible deliverable FX forward from the exemption. More specifically, a "deliverable" currency forward must be settled by an actual exchange of currencies and - again absent clarification - may not be settled by entering into an offsetting "deliverable" transaction prior to the Settlement Date of the original transaction taking advantage of netting mechanisms in a master agreement (i.e., ISDA, FEOMA, etc.) with the "out of the money party" making a net payment to the other party. Or, to put it more simply, to qualify from the central clearing exemption, every FX Forward will need to settle by an actual exchange of currencies on Settlement Date, if the proposed interpretation is read literally. 

So, for the sake of discussion, if an FX forward is a "Deliverable Transaction" (in the language of the 1998 FX and Currency Option Definitions) on Trade Date, then a literal reading of the interpretation means that it MUST physically settle on Settlement Date. Does that mean that trades formerly documented as deliverable FX forwards and settled via netting/offset will now be documented as NDFs?

Seems like an issue ripe for clarification in comment letters.

THE DEPARTMENT'S PRESS RELEASE

The remainder of this positing is an excerpt from the Department's Press Release (available here):

This proposed determination is narrowly tailored. FX swaps and forwards will remain subject to Dodd-Frank’s rigorous new trade reporting requirements and business conduct standards. Additionally, the Dodd-Frank Act makes it illegal to use these instruments to evade other derivatives reforms. Importantly, the proposed determination does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards.  These other FX derivatives will be subject to clearing and exchange requirements.

The FX Swaps and Forwards Market Operates with High Levels of Transparency, and Dodd-Frank Will Further Increase Transparency

• Market Pricing Transparent and Readily Available. Unlike other derivatives, FX swaps and forwards already trade in a highly transparent, liquid, and efficient market. FX swaps and forwards are heavily traded on electronic platforms, and market pricing information is readily available from a number of sources.
• Additional Transparency through Dodd-Frank. Dodd-Frank’s trade-reporting requirements for FX swap and forward transactions will further improve the information available to regulators and their ability to oversee this market and its participants.

A Number of Unique Factors Limit Risk in FX Swaps and Forwards Market 

• Fixed Terms, Physical Exchange of Currency. In contrast to other derivatives, FX swaps and forwards always require both parties to physically exchange the full amount of currency on fixed terms that are set at the outset of the contract. Market participants know the full extent of their own payment obligations and their exposure to the other party to a trade throughout the life of the contract.  
• Well-functioning Settlement Process. Because FX transactions involve the actual exchange of currency, settlement risk (the risk that one party to an FX transaction will pay the currency it sold but not receive the currency it bought), is the main source of risk in these transactions. The strong, internationally coordinated oversight of this market led to the establishment of a well-functioning settlement process that effectively addresses this risk. There is extensive use of payment systems that permit the transfer of one currency to take place only if the final transfer of the other currency also takes place.
• Shorter Duration Contracts. FX swaps and forwards are predominantly short-term transactions (68 percent of the market matures in one week or less and 98 percent in one year or less). Other derivatives have much longer average maturity terms, ranging from two to thirty years. Because of their short duration, FX swaps and forwards pose significantly less counterparty credit risk than other derivatives. 

FX Swaps and Forwards Are Subject to a Strong, Comprehensive Oversight Framework That Dodd-Frank Further Strengthens

• Subject to Strong, Comprehensive Oversight for Three Decades. The FX swaps and forwards market and its key participants have been subject to strong, comprehensive, and internationally coordinated oversight by central banks for more than three decades. Prudential regulators impose capital and margin requirements and monitor the use of FX-related settlement arrangements and other measures to reduce counterparty credit risk.  Through the Basel Committee on Banking Supervision and the Committee on Payments and Settlement Systems, central banks and prudential regulators continue to strengthen already robust risk management and settlement practices of FX market participants.
• Oversight of FX Swaps and Forwards Further Strengthened through Dodd-Frank. The Dodd-Frank Act provides the Commodity Futures Trading Commission (CFTC) and banking regulators with additional oversight of the participants in the FX Swaps and Forwards market. It subjects these participants to heightened business conduct standards.  It also provides the CFTC with strong powers to prevent market participants from using FX swaps and forwards to evade requirements imposed on other derivatives.​

Good day. Good reading. TSR

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Just a few moments ago, the CFTC issued an Order Relating to the Continuation, Shutdown and Resumption of Certain Commission Operations in the Event of a Lapse In Appropriations" - it is an interesting read and available here.

In summary, as of 12:01 a.m. on April 9th (that is in less than 4 hours), the continuing resolution that funds many federal government activities is set to expire and, in the absence of additional appropriations, federal agencies like the CFTC will be required to execute contingency plans...enter the aforementioned Order.

So, what will the CFTC be doing and what will it not be doing during a Federal government shutdown?

By law, the CFTC can only deal with "emergencies involving the safety of human life or the protection of property."

The CFTC will be dealing with matters related to the Protection of Property. These consist largely of dealing with filing obligations imposed on registered entities, intermediaries, market participants and the public -- such as, FCM financial reports and capital requirement filings, clearing member reports, reports by traders, and bona fide hedge position reports. These are listed on p. 5 and 6 of the Order.

The CFTC will NOT be dealing with matters NOT Related to Protection of Property. So, that means no rules, rule amendments, bona fide hedge requests under rules 1.47 and 1.48, and a wide variety of what we call "normal regulatory activity" - you can view this list by looking at pages 3 and 4 of the Order. Furthermore, the deadlines in respect of all actions pending before the CFTC will be tolled.

AND WHAT DOES THIS MEAN FOR PURPOSES OF DODD-FRANK RULEMAKING AND ANY OTHER PROPOSALS DUE NEXT WEEK?

For this, we will quote directly from the Order:

Finally, the [CFTC] has proposed a number of rules to implement the Dodd-Frank Act for which the comment period may expire while the Commission is shutdown. The [CFTC] will be unable to officially receive and process comment submissions until it resumes full operations. Therefore, the [CFTC] is extending the comment periods for such rules, and for any other matters that may be subject to a request for comment by the [CFTC], until one business day after the [CFTC] is able to resume full operations. Notice of the lifting of a shutdown will be provided on the Commission's website.

AND WHAT PROPOSALS MIGHT THIS AFFECT?

What a great question!

Comments Due 4/11:

Orderly Liquidation Termination Provision in Swap Trading Relationship Documentation for Swap Dealers and Major Swap Participants

Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants

Requirements for Processing, Clearing and Transfer of Customer Positions

Comments Due 4/12:

CPO and CTA: Amendments to Compliance Obligations

Reporting by Investment Advisers to Private Funds and Certain CPOs and CTAs

The list of ALL open comment periods is available here.

Good reading. Good weekend. TSR

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The CFTC has announced that it will hold its (rescheduled) 13th Public Meeting on Dodd-Frank Reforms on Tuesday, April 12th at 9:30 a.m. EST.

On the agenda..."Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants"...

Press Release and "How to Participate" is available here.

Good day. Good reading. TSR.

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On March 29th, ISDA released a paper entitled, "Swap Execution Facilities: Can They Improve The Structure of OTC Derivatives Markets?"

The paper provides a good overview of what is and is not a SEF and how the regulators - SEC with respect to security-based SEFs and CFTC with respect to SEFs - have proposed regulating these soon-to-be-established, soon-to-be-regulated entities. After reading the piece, one cannot help but  walk away with the understanding that ISDA's view is that SEF's are not futures exchanges, should not be treated like futures exchanges, and need to be understood for what they are: a facility that affords market participants with the ability to execute OTC derivatives with other market participants in a cost efficient manner. Further, ISDA argues, SEF's can not be properly regulated until they are properly understood.

While we certainly agree with ISDA, we note that the very appealing theory of the SEF can cloud the vision, making it difficult to properly understand what a SEF is or is not. What is this very appealing theory? That SEFs are a panacea (or, at least, the next best alternative to a panacea) for bringing about the second of the four objectives of Dodd-Frank's reforms: Promoting Efficiency and Transparency of OTC Markets.

On a related note, there is some really interesting information in a table at the top of page 13 of the paper. This table is entitled, "OTC Swap Market vs. Listed Futures Market" and it is definitely worth your time to look at it.

Good day. Good reading. TSR

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Financial Times blogger Tracy Alloway quoted Andrew Cross, editor-in-chief of TSR, in a recent posting entitled, "CDS Options Market Multiplies Alongside Questions" - it is a good read, if you are interested in CDS index options. Who wouldn't be???

Good day. Good reading. TSR

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In March 22nd remarks to the European Parliament's Economic and Monetary Affairs Committee, Chairman Gensler outlined his views on the status and direction of derivatives market regulatory reforms in the U.S. and Europe. At the end of this posting, we have set forth several excerpts from Chairman Gensler's speech that we thought were interesting  - scan through the headings and read what interests you.

As I have mentioned to friends and clients recently, it is my personal view that a global structure for the derivatives markets will emerge that will substantially restrict regulatory arbitrage. In other words,  5 to 10 years from now, it may not be as realistic as some think to "run to jurisdiction X" and operate from that location, so as to avoid some of what may be perceived as being "less desirable" regulatory tools given to U.S. regulators by Congress - clearing, reporting, and execution mandates, as well as registration and oversight of significant market participants.

The derivatives markets are connected and policymakers worldwide appear to view these regulatory tools as the most efficient way to reduce global systemic risk (see, e.g., IOSCO's March 10th policy paper, "Principles of Financial Markets Infrastructure"). Of course, if it turns out that such efficiencies do not work as intended - but rather serve to concentrate systemic risk in several multinational market intermediaries and facilities - then the next period of market stress might be known as Too Big To Stand (T.B.T.S. for those who like acronyms).  

Good day. Good reading. TSR.

EXCERPTS FROM CFTC CHAIRMAN GENSLER'S MARCH 22ND SPEECH TO THE EUROPEAN PARLIAMENT'S ECON COMMITTEE

ON THE SCOPE OF REFORMS:

Like the U.S. law, the [E.C.'s] swaps proposal released last year covers the entire swaps marketplace - both cleared and uncleared...Furthermore it is essential that reform covers all swaps transactions, regardless of where they are executed.

ON THE REGULATION OF DEALERS:

The Dodd-Frank Act includes comprehensive regulation of swap dealers. Though the E.C.'s proposal is organized differently, it includes many of the same critical components for the regulation of dealers, including capital and margin, risk mitigation techniques and reporting.

ON THE REGULATION OF NON-FINANCIAL END-USERS:

Recognizing that swaps transactions involving non-financial end-users to not pose the same risk as transactions between two financial entities, Congress excepted these transactions from mandatory clearing, and, thus, the CFTC does not intent to impose margin requirements with regard to these transactions.

ON THE APPLICATION OF THE CENTRAL CLEARING MANDATE TO FINANCIAL END-USERS:

In the U.S., Congress determined that the end-user exception should be limited to non-financial entities. Expanding the exception to include financial end-users, such as hedge funds, insurance companies or pension funds, would leave significant risk and interconnectedness in the financial system. If pension funds or other financial entities, for example, do not benefit from central clearing, they will remain interconnected with their swap dealers. This increases the risk that the dealer's failure could spread to the pension funds or other financial entities. Central clearing lowers that interconnectedness and lowers the risk that taxpayers might be called upon to bail out a dealer if it should fail.

ON THE SHARING OF INFORMATION WITH NON-U.S. REGULATORS:

It is important that all swaps - both on-exchange and off - be reported to [swap] data repositories so that regulators can have a window into the risks posted in the system and can police the markets for fraud, manipulation and other abuses.

The U.S. statute says that information in [SDRs] that we regulate should be available to foreign regulators...We look forward to working with our international counterparts on arrangements to ensure that necessary data in [SDRs] be available to foreign regulators.

ON THE REGULATION OF PHYSICAL COMMODITY MARKETS:

Though the CFTC is not a price-setting agency, we have a number of tools to help ensure market integrity and protect against fraud and manipulation. This includes position limits, anti-manipulation authorities, large trader reporting and pre-trade risk safeguards. As it relates to anti-manipulation, we have authorities to pursue both manipulation and attempted manipulation. I understand you are taking that up in the Market Abuse Directive. We strongly support providing regulators the power to deter and prosecute attempts to manipulate the market.

ON THE REGULATORY TREATMENT OF EXISTING TRANSACTIONS:

Regardless of the eventual effective dates of the swaps rules, to provide regulatory certainty to the market, rules relating to mandatory clearing, real time reporting, the trading requirement, margin and business conduct standards will apply only prospectively to those transactions that are executed after the rules go into effect.

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In a March 16th No-Action Letter, LCH.Clearnet Limited ("LCH") received a no-action letter from the SEC's Division of Investment Management ("IM Division") that, in effect, permits a mutual fund to "place and maintain assets in the custody of" LCH or a clearing member of LCH (the "Clearing Member") for purposes of meeting margin requirements for interest rate swaps that are cleared by LCH.

In summary, the no-action relief was required, since

1) Section 17 of the Investment Company Act mandates that a mutual fund to maintain its securities and similar instruments with qualified custodians; and

2) The regulatory exception to this statutory mandate - SEC Rule 17f-6 - permits a mutual fund to post initial margin in respect of futures contracts and options on futures at a futures commission merchant, but does not apply to centrally cleared over-the-counter interest rate swaps ("IRS").  

The IM Division conditioned the no-action relief on the satisfaction of the requirements of Rule 17f-6 by LCH and the CM and the application of those requirements to centrally cleared IRS. The no-action relief expires on July 16th of this year, concurrent with the effective date of the Dodd-Frank mandates in respect of derivatives market regulatory reforms.

The IM Division has already granted similar relief to the CME and ICE Trust in respect of centrally cleared CDS.

Good day. Good reading. TSR

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On March 10th, the CFTC issued a rule proposal in respect of its Requirements for Processing, Clearing, and Transfer of Customer Positions and provided swap market participants with another piece of the soon-to-be, everyday tradeflow for centrally cleared swap transactions.

In summary, the rules would establish:

1) A timeframe for the processing of a cleared swap by a swap dealer, MSP, FCM, SEF and DCM;

2) The process for the transfer of open swap positions from a carrying clearing member (CM) to another CM without unwinding and re-booking the position.

We will look at each aspect of the proposal, in turn.

TIMEFRAME FOR PROCESSING A CLEARED SWAP

The CFTC is also requiring that SEFs and DCOs (i.e., the execution and clearing market utilities, respectively) develop rules and procedures to facilitate "prompt and efficient transaction processing".  The standard also applies to swaps executed through a DCM, rather than a SEF.

As part of the proposal, the CFTC is specifically seeking comments from asset managers in respect of the amount of time required to allocated block trades, prior to the submission of the allocated trades to clearing (i.e., end of day, two hours, etc.).

2) TRANSFER OF CUSTOMER POSITIONS AND RELATED FUNDS

The proposed rules apply to cleared swaps and require a DCO (i.e., the clearinghouse or CCP, as you may prefer) to "facilitate a prompt transfer of customer positions" from one clearing member (CM) to another clearing member. A brief quote is in order:

Efficient and complete portability of customer positions and funds related to those positions is important in both pre-default and post-default scenarios. A DCO should therefore structure its portability arrangements in a way that facilitates the prompt and efficient transfer of all or a portion of a customers positions from one clearing member to one or more other clearing member.

Q: What does "prompt" mean?
A: "As soon as possible and within a reasonable period of time."

The CFTC then looks to the current futures industry standards for guidance - the transfer should occur within two business days.

( Note: The two day standard is not the time frame used in the rule. Rather, the rule uses the qualitative standard of "ASAP and within a reasonable period of time," since the CFTC expects improvements to technology will result in the transfer of cleared customer swaps more quickly and with greater operational efficiency.)

Finally, the rule proposal would require the positions to be transfer without having to be closed-out and re-booked.

PROMPT AND EFFICIENT SEEMS TO BE OUR THEME FOR THIS RELEASE. WE HOPE THIS POSTING MET THE STANDARD.

Good day. Good reading. TSR

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For those of you who have negotiated even a single ISDA on behalf of a non-dealer counterparty, you know how frustrating it is to be on the receiving end of this response (i.e., to a requested change to an draft ISDA Schedule during the course of your negotiation):

THAT TERM IS PART OUR TEMPLATE AND, IN ORDER TO MODIFY IT, I WILL NEED APPROVALS OF  _______________(SENIOR MANAGEMENT, CREDIT COMMITTEE APPROVAL, ETC.). I CAN ASK, BUT IT WILL SLOW THINGS DOWN. (Query: Weren't things already slow?)

Well, the good news is that you may not hear that statement ever again, if the CFTC adopts certain  documentation standards as proposed last month (see Swap Trading Documentation Requirements for Swap Dealers and Major Swap Participants).

The bad news, however, is that you may hear the following statement in its stead:

THAT TERM IS PART OF OUR TEMPLATE - THE NEW CFTC RULES REQUIRE THAT WE KEEP IT STANDARDIZED, SINCE STANDARDIZATION AND SYSTEMIC RISK ARE INVERSELY CORRELATED. SORRY. WHY DON'T YOU JUST SIGN THE FORM NOW. 

On what possible basis could we make such an absurd claim??? We took creative license and extrapolated it from the following statement - which was made by the CFTC in the aforementioned rule proposal:

Swap dealers and major swap participants could maintain standard templates for documenting their trading relationships as a way of complying with the requirements of Sec. 23.504. The Commission would also consider it a sound practice for swap dealers and major swap participants to require senior management in the business trading and risk management units to approve all templates, and any material modifications to them.

So, here are a few follow-up thoughts on standardization.

1) Swap dealers already do maintain standard templates. Their counterparties - the other principal to the transaction - negotiate changes to those templates. Not always easy to do, but nothing worthwhile ever is.

2) Standardization makes sense in the case of a trade confirmation for a cleared swap. It makes even more sense if the swap is executed through a SEF or a DCM.

3) It makes some sense in the case of documentation required to open a trading account (think futures customer agreement); but, even there the parties can and do negotiate those agreements. Admittedly, the negotiation is less intense due to the fact that the customer transacts through its FCM (so, more of an agency relationship, rather than a principal-to-principal trading relationship, as is the case with the ISDA-based relationship) and the FCM has regulatory obligations that transcend the preferences of any one customer. [And, FYI, we expect that negotiating centrally cleared OTC documentation will feel alot like negotiating futures customer agreements, but without all of the customer friendly provisions - that was a joke.]

4) It makes no sense with respect to bi-laterally executed, non-cleared transactions.  Indeed, ESPECIALLY WITH RESPECT TO SUCH TRANSACTIONS (which themselves are not standardized), the parties should customize the relationship level documentation through the negotiation process.  The paradox is impossible to not see: a standardized relationship for non-standardized transactions.

Maybe we are over-reacting. Maybe dealers will not react in the manner that we outlined above. 

What can you do? Sharpen your pencils. Tap the keyboards. Shape the regulatory history - the comment period is open until April 11th. That is one month from today - that's a lifetime in Dodd-Frank implementation phase.

Good day. Good reading. TSR.

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The Proposed Interpretive Order is available here. It has not yet been published in the Fed Reg.

SUMMARY OF DODD-FRANK SECTION 747

Effective July 16, 2011, Section 4(c)(a)(5) of the CEA (added by Section 747 of Dodd-Frank) will prohibit the following “disruptive practices” in respect of trading, practices or conduct in respect of exchange-traded futures contracts, as well as any OTC derivative that is executed through a swap execution facility:

1) Trades that violate bids or offers;

2) Bidding or offering with the intent to cancel the bid or offer before execution – the provision requires specific intent not to stand by a bid or offer at the time it is placed (so-called “spoofing”); and

3) Any trading practice or conduct that “demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period;” and

4) Any other trading practice determined by the CFTC to be disruptive of “fair and equitable trading”.

Similar to the recklessness standard in the anti-manipulation context, these prohibitions have left market participants uncertain as to what conduct will constitute impermissible disruptive trading.

SUMMARY OF THE PROPOSED INTERPRETIVE ORDER

In an Interpretive Order dated February 24^th, the CFTC provided the following additional guidance in respect of these prohibitions on disruptive trading practices:

1) A trade will not become subject to Section 4(c)(a)(5) solely because it is reported on a swap data repository;

2) Section 4c(a)(5) will not apply to block trades or exchange for related positions transacted in accordance with the rules of an futures exchange or a SEF;

3) Section 4c(a)(5) will not apply to bilaterally negotiated OTC derivatives;

4) Violating a Bid or Offer - The CFTC interprets “violating a bid or offer” in Section 4c(a)(5)(A) 1) to mean buying at a price that is higher than the lowest available offer price or selling at a price that is lower than the highest available bid price 2) without regard to the intent of the trader; and 3) to not apply to “buying the board,” which is defined by the CFTC to mean executing a sequences of trades to buy all available bids or offers on that order book in accordance with the rules of the facility on which the trades were executed;

5) Orderly Execution of Transactions During the Closing Period – The CFTC has emphasized that a market participant must act recklessly and, as such, Section 4c(a)(5)(B) is not “a trap for those who act in good faith” (U.S. v. Ragen, 314 531, 524 (1942)). The CFTC interprets “closing period” to mean the period in the contract or trade when the daily settlement price is established. In a footnote, the CFTC explained that, “…absent an intentional or reckless disregard for the orderly execution of transactions during the closing period, a person would not be liable under Section 4c(a)(5)(B) upon executing an order during the closing period simply because the transactions had a substantial effect on the settlement price.”

6) Spoofing -- The CFTC noted that Section 4c(a)(5)(C) includes has an intent requirement. Thus, reckless – as well as accidental or negligent – trading, conduct, or practices, will not result in violations of the spoofing prohibition in Section 4c(a)(5)(C). Orders, modifications, or cancellations do not constitute spoofing if they were submitted as part of a legitimate, good-faith attempt to consummate a trade. Likewise, legitimate, good faith cancellations of partially filled orders will not violate the Spoofing prohibition. The following are examples of prohibited spoofing:

            A trader places an order with the intent to cancel it, but the order is subsequently filled.

            A trader submits or cancels bids to overload the quotation system of an exchange or SEF.

            A trader submits or cancels bids or offers to delay another person’s execution of trades.

            A trader submits or cancels multiple bids or offers to create an appearance of false market depth.

A single instance of trading activity can be disruptive of fair and equitable trading and, as such, a spoofing violation does not require a pattern of activity.

Good day. Good reading. TSR.

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Our Firm will host a Teleseminar on February 24th at 12:00 p.m. EST - summary is set forth below.  This telesminar touches many different topical areas, so derivatives represent one piece.

To register contact:

Sandy Petrakis
E: spetrakis@reedsmith
T: 412-288-3131

Good day. Good registration. TSR

Dodd-Frank - What Happened and What's Next 

What amendments may be brewing? What congressional oversight sessions are planned to influence regulators? Where do regulators stand on the key tasks delegated to them? To help answer these questions and many others, we introduce our newest colleague, Mark Oesterle, former Senate Banking Committee Counsel.

Join Mark and a panel of experts from Reed Smith on Thursday, February 24 at 12 p.m. (EST) as they present an informative "pulse check" on the status of Dodd-Frank developments.

Mark will kick off the teleseminar with a crystal ball look at Dodd-Frank - what has happened over the past six months and what lies ahead. Mark recently joined Reed Smith as Counsel in our Washington, D.C. office after spending many years on Capitol Hill, most recently as Chief Minority Counsel for the U.S. Senate Committee on Banking, Housing and Urban Affairs. He also served as Chief Counsel and Republican Deputy Chief of Staff, Parliamentarian, senior advisor to the Chair, and counsel to the Financial Institutions Subcommittee during his tenure of more than a decade.

In addition, our diverse panel of partners will discuss current hot topics related to Dodd-Frank, including:

• Derivatives - Andrew Cross
• Investment and Municipal Adviser Issues - Alicia Powell and Fred Leech
• Executive Compensation - Jeffrey Aromatorio
• The Financial Stability Oversight Council and the Volcker Rule - Michael Bleier
• Consumer Financial Protection - Len Bernstein
• Litigation and Enforcement - Tom Allen

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Over the past two weeks, a discussion has ensued between lawmakers and policymakers tasked with implementing derivatives market regulatory reforms under Dodd-Frank. At a high level, (mainly) Republican lawmakers have been repeating the mantra, "Dodd-Frank is not intended to impose margin requirements on end-users and doing so will hurt Main Street by making derivatives trading more costly for these entities." Although, given the July 2010 colloquies from Democratic lawmakers that are part of the legislative history of Title VII, this can hardly be called a "Republican" idea. Indeed, even more recently, 3 Democrats and 10 Republicans penned a letter that lawmakers to avoid the imposition of margin requirements on end-user trading. So, it can be said that there is bi-partisan support for the position of "no margin for end-users," which reflects the legitimate concerns of a diverse number of market participants that are certain to be represented by Republicans, Democrats, liberals, conservatives and political agnostics.

TSR agrees that end-user margin requirements will have a detrimental effect on a wide swath of commercial end-users that, in turn, could make life more expensive for everyday consumers, travelers, etc. But, we feel that the direct imposition of margin requirements on end users is, well, a marginal issue. The fact of the matter is that the panoply derivatives regulatory reform initiatives will make derivatives trading more expensive  - significant investments of time and resources are being made and will be made to build the new market infrastructure required to implement this legislative and regulatory mandate. Unless Congress and policymakers make it illegal for dealers, major participants, swap data repositories and other market participants to pass along these implementation costs to their customers (please NO!), the imposition of direct margin requirements on end-users is only one of many increased costs that end-users will face. (To this end, we note that increased margin and capital requirements on financial entities would also seem to make derivatives trading more expensive for end-users for the same reason - profit maximizing enterprises tend to shy away from eating costs. See Op-Ed: Will The Costs of Hedging As A Result of The Dodd-Frank Act? TSR, October 28, 2010).

In conclusion, although not spoken of in these terms, Title VII of Dodd-Frank is an insurance program designed, in large part, to prevent a Main Street bailout of Wall Street. Presumably, Congress decided that the premium dollars (i.e., the costs of its implementation) are worth spending for the insurance coverage (i.e. reduce systemic risk, increase transparency and efficiency of markets, prevent fraud and manipulation, protect customers) . Whether or not it is money well spent will be for the "future" to decide - but, this much is certainly understood by most of us from our personal experience: you can not spend the same dollar on insurance as you do on a movie ticket, dinner at a restaurant, etc. And, if the costs of insuring that Main Street does not bail out Wall Street were not properly considered, then derivatives market regulatory reform just might turn out to be the "Nightmare on Main Street" - playing at a theater near you. Only time will tell .

Good day. Good reading. TSR.

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Two current events in Washington, D.C. worth noting - a common theme, "prescriptive".

First, 13 Senators (10 Repubicans; 3 Democrats) sent a letter dated February 8, 2011 to Secretary Geithner and Chairmen Bernanke, Gensler, and Schapiro. The letter focused on the end-user exemption and the central themes were:

1) Do not impose margin requirements on end-users, since doing so could drain "scarce working capital from the balance sheets of mainstream American companies";

2) Do not mandate central clearing for end-users, since that could cause the companies to "forego the benefit of these important risk management tools"; and

3) Do not impose margin requirements on a retroactive basis, "as doing so would upset the expectations of countless end-users and call into questions years of contract law" (emphasis added on an editorial basis, as some former owners of the capital structure of General Motors have been rumored to believe that the concern just might apply to a broader group of market participants than end-users); and

4) Prevent a migration of the derivatives market overseas in response to an "an overly prescriptive" U.S. regulatory structure.

Phil Mattingly of Bloomberg has a good summary that can be accessed  here.

Second, Congressman Mike Conaway of Texas (Chair of General Farm Commodities and Risk Management Subcommittee of House Agriculture Committee) admonished CFTC Chairman Gensler to "be judicious regarding the CFTC's expanded authority, to tailor their rules narrowly, and to respect the intent of Congress when interpreting their mandates." To this end, Chairman Conaway further noted, "Unintended consequences are the hallmark of prescriptive regulations considered in no logical or systematic sequence and in a seemingly rushed manner."

Good day. Good reading. TSR

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Two different events occurred on January 26th that we believe represent a microcosm of the entire U.S. derivatives regulatory reform process to date.

EVENT #1: THE JANUARY 26TH PROPOSAL

The 11th open meeting on Dodd-Frank derivatives market regulatory reforms was scheduled to be held by the CFTC. While the agenda included issues related to the CFTC's mandate under Dodd-Frank, the CFTC took the opportunity to approve a rule proposal that is at best tangentially related to - but by no means mandated by - the Dodd-Frank Act. Specifically, the CFTC voted to alter existing regulatory exemptions available to mutual funds under CFTC Rule 4.5.  which inter alia exempts mutual funds regulated by the SEC from duplicate, and possibly conflicting, regulation by the CFTC as "commodity pool operators" (the "January 26th Proposal")

According to the CFTC, the January 26th Proposal - which at the time of this posting had not yet been published - will be based upon a petition filed with the CFTC last year by the National Futures Association. The effect of the proposal will be to restrict the ability of a mutual fund to use commodity futures and options for purposes other than hedging, unless that mutual fund is regulated by the CFTC as a "commodity pool operator". In particular, as we explained in a September 21st (2010) posting entitled CFTC Rule 4.5: Back to the Future, the NFA recommends the following restriction:

A mutual fund may use commodity futures or commodity options contracts solely for bona fide hedging purposes (a term of art under the commodities laws) and, with respect to positions that may be held by the fund only for non-bona fide hedging purposes, the aggregate initial margin and premiums required to establish such positions will not exceed five percent of the liquidation value of the qualifying entity's portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into.

We refer to this as the "5% test" and, as noted, it appears to be a key element of the January 26th Proposal.

 EVENT #2: THE JANUARY 26TH LETTER

Second, Rep. Frank Lucas (R- OK) and Rep. K. Michael Conaway (R-TX) sent a letter (the "January 26th Letter," available here)  to the chairman of the Commodity Futures Trading Commission (CFTC), Gary Gensler, requesting that the agency voluntarily adhere to President Obama's recent executive order, since that order requires other affected Federal agencies to "evaluate costs and benefits before issuing regulations, foster open debate and dialogue about pending rules, and among other things, minimize the burden new regulations impose upon businesses." (the January 26th Letter). 

A SIDE-BY-SIDE LOOK AT CONCERNS OVER THESE TWO EVENTS

We will now take a side-by-side look at concerns raised by:

• The Swap Report several months ago over the NFA's petition (and now applicable to the January 26th Proposal); and
• Representatives Lucas and Conaway in the January 26th Letter over the U.S. derivatives reform process.

Just in case you do not see what we see, we will be more direct - derivatives regulatory reforms are being implemented in a manner that does not allow the many industries that may be subject to the new regulations to fully comprehend the inter-relationships among various aspects of the reform proposals and the effect of such proposals on each respective industry.

We do not believe that this is the intention of the CFTC and the SEC with respect to the regulatory reform process. However, we do believe that this is a common experience for an extremely wide range of industries and businesses that will be affected by U.S. derivatives regulatory reforms.

By the way, "microcosm" comes from the Greek words mikros cosmos and literally means "little world" ("Give me a word, any word, and I show you that the root of that word is Greek."
with a tip of the hat to Kostas "Gus" Portokalos).  

Good day. Good reading. TSR

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Links to Relevant Documents; Overview of Relevance

A joint SEC/CFTC Rule Proposal for Reporting on Form PF by Investment Advisers,  Commodity Trading Advisors, and Commodity Pool Operators to Private Funds available here

A Press Release and a Fact Sheet for new CFTC rule proposals that will effect mutual funds (registered investment companies), hedge funds, registered investment advisers, commodity pool operators, and commodity trading advisers available here

Here is a synthesized (and hopefully short enough for you) version of why this is relevant to the funds and advisory communities - registered and private, commodity and investment, Steelers and Packers (and, with all due respect to our friends in Green Bay, fuh-ged-a-baht-it; Championship No 7 is coming back to Pittsburgh).If you manage money and invest in derivatives, this is ALL very important.

Private Hedge Funds & Their Registered Investment Advisers; CPOs & CTAs

The SEC has proposed a rule that would require investment advisers registered with the SEC that advise one or more private funds to file Form PF with the SEC.  The CFTC has joined in the proposal and requires CPOs and CTAs registered with both the CFTC and SEC (dual registrants) to satisfy proposed CFTC filing requirements by filing Form PF with the SEC. Here is the summary from the joint SEC and CFTC proposal:

In summary, the report will require a description of information about the private fund, including the amount of assets under management, use of leverage, counterparty credit risk exposure, and trading and investment positions for each private fund advised by the adviser.

A similar reporting requirement - Form CPO-PSR and CTA-PR -is proposed by the CFTC with respect to CPOs and CTAs that are NOT dual registrants. These forms will be filed with the National Futures Association, similar to other required filings under the U.S. commodities laws.

CFTC Rule 4.5: Mutual Funds Wake Up

We have written about the NFA's petition from summer 2010 on a number of different occasions here at TSR - we encourage you to go back and read those commentaries (search TSR for "Back to the Future" and / or "CFTC Rule 4.5").

Why? Because the CFTC has approved a rule proposal (not yet issued) that would, in effect, amend CFTC Rule 4.5 exemption for registered investment companies in a manner consistent with the NFA's 2010 petition.

CFTC Rule 4.13(a)(3) and (4): Hedge Funds Wake Up

At yesterday's meeting, the CFTC approved a rule proposal (not yet issued) that would RESCIND the registration exemptions available under these rules, which are relied on by many hedge funds for offering private funds that use futures as part of their investment strategies.

Annual Filing Requirement for Hedge Funds, Mutual Funds, CPOs, CTAs, Investment Advisers

So, you all used to claim your exemptions once and for all by filing a notice filing under any one or more of the applicable CFTC Rules - Rules 4.5, 4.13 and 4.14. Well, yesterday the CFTC proposed any person claiming exemptive or exclusionary relief under CFTC Rules 4.5, 4.13 and 4.14 to confirm their notice of claim of exemption or exclusion on an annual basis.

Allow us to translate for you: YOU WILL HAVE A NEW ANNUAL FILING REQUIREMENT TO STAY ON TOP OF - GET IT.

More to come on all of this, but wanted to get it onto your radar sooner rather than later.

Good day. Good reading. TSR

"The Commodity Futures Trading Commission ("CFTC") and the Securities and Exchange Commission ("SEC") (collectively, "we" or the "Commissions") are proposing new rules under the Commodity Exchange Act and the Investment Advisers Act of 1940 to implement provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed SEC rule would require investment advisers registered with the SEC that advise one or more private funds to file Form PF with the SEC. The proposed CFTC rule would require commodity pool operators ("CPOs") and commodity trading advisors ("CTAs") registered with the CFTC to satisfy certain proposed CFTC filing requirements by filing Form PF with the SEC, but only if those CPOs and CTAs are also registered with the SEC as investment advisers and advise one or more private funds. The information contained in Form PF is designed, among other things, to assist the Financial Stability Oversight Council in its assessment of systemic risk in the U.S. financial system. These advisers would file these reports electronically, on a confidential basis."

A Press Release and a Fact Sheet in respect of the joint rule proposal available here

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This is the 12th AND FINAL posting of a 12-part series on a December 7th rule proposal (75 Fed Reg 80174) by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, and eligible contract participant.

In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively. Specifically, we turn our attention to a panoply of interpretive issues regarding the major participant definitions raised by commentators since the enactment of Dodd-Frank and with respect to which the regulators are now seeking further comment.

1) The scope of the exclusion from the first major participant test that is available for ERISA plans;

2) The application of the major participant definitions to clients of an investment adviser (which are referred to by the Regulators as "managed accounts");

3) The application of the major participant definitions to positions of affiliated entities;

4)The application of the major participant definitions to inter-affiliated swaps and SBS;

5) The major participant status of entities that maintain "legacy portfolios" of CDS previously entered into in connection with the activities of monoline insurers and "credit derivative product companies." (Give me an A! Give me an I! Give me a G! What's it spell? LOTS OF SWAPS! Louder, LOTS OF SWAPS! Louder, LOTS OF SWAPS!); and

6) Potential exclusions for ERISA plans, registered broker-dealers, registered investment companies, registered futures commission merchants, and long-term investors such as a sovereign wealth fund.

It is all very exciting, as you will no doubt agree when you read below. But, first, our Prologue.

Prologue: OH, WE'RE THE BOYS OF CHORUS, WE HOPE YOU LIKE OUR SHOW...

A 12 PART SERIES. It has been real. It has been nice. It has even been real nice. The ups and the downs of the three major participant tests. What a mind blower hedging vs. speculating vs. trading is, huh? Hey, how about the old HMCR exemption - you loyal TSR readers know what we mean (rookies out there - go read Part 8).

We started this whole jaunt in the previous decade. We know your rootin' for us - but now its time to go...Not so fast. Two items:

1) We have to cover the interpretive issues; and

2) I'VE GOT A FEELIN', PITTSBURGH'S GOIN' TO THE SUPERBOWL

Ok. Let's get back to what you did not pay for.

Exclusion for ERISA Plan Positions

Remember the first major participant test? (See Parts 5 and 6 and 7 of this TSR special series, if you just started to tune in. )

As you might recall this from the earlier postings, the first test excludes "positions maintained by any employee benefit plan...as defined in paragraphs (3) and (32) of ERISA...for the primary purposes of hedging or mitigating ANY RISK DIRECTLY ASSOCIATED WITH THE OPERATION OF THE PLAN" - we, not Congress, added the emphasis. (When Congress adds emphasis it uses commas and the USD symbol, not bold, All Caps.)

Many commenters urged the Regulators to clarify that the exclusion encompasses activities such as portfolio rebalancing and diversification, gaining exposure to alternative asset classes and other investment management functions related to the implementation of the plan's investment strategy.

The Verdict: No new rule proposal. Here is what the Regulators had to say:

We preliminarily do not believe that it is necessary to propose a rule to further define the scope of this exclusion. In this regard, we note that this ERISA plan exclusion...is not limited to "commercial" risk...[AND] may be construed to mean that hedging by ERISA plans should be broadly excluded.

That is probably good news for ERISA plans. But, bad news for lawyer who has ever tried to explain the hedging vs. spec distinction to their clients for other purposes. And, it is worth noting that the Regulators have left the door open for making this exclusion available for other entities (but, did not yet officially make that proposal).

Investment Advisory Clients

The Regulators refer to an investment adviser's clients as "managed accounts" - we at TSR will use that term, but want to make sure for any of our reader base familiar with investment management lingo - THE REGULATORS DON'T MEAN SEPARATELY MANAGED ACCOUNTS OR ANY OTHER TERM THAT YOU MAY USE WHEN TALKING ABOUT MANAGED ACCOUNTS. Rather, they just mean an account that is managed by a money manager.

So, what was the concern? Well, some commenters wanted the Regulators to clarify that the manager will not be deemed to be a major participant by virtue of the swap and SBS positions held by their clients. Other commentators wanted clarity regarding aggregation - in other words, different

Good news. The concerns have been addressed (although through comments, rather than as a rule proposal per se). Here is an excerpt from the December 7th proposal:

[W]e do not believe that the major participant definitions should be construed to aggregate the accounts managed by asset managers or investment advisers to determine if the asset manager or investment adviser itself is a major participant. The major participant definitions apply to the entities that actually "maintain" substantial positions in swaps...In addition, we note that since the major participant definitions focus on the entity that enters into swaps or SBS, all of the managed positions of which a person is the beneficial owner are to be aggregated (along with such beneficial owner's other positions) for purposes of determining whether such beneficial owner is a major participant.

Hey, that bold stuff is interesting. So, any pooled investment vehicle with multiple managers needs to be looking at its aggregate swap or SBS portfolio across those managers for purposes of the major participant test. Very interesting indeed...should not be a problem though, since everybody takes aggregate snapshots of their OTC derivative positions across all of their managers and every investment manager provides the same style of derivative reports to their clients. Also, the risk of entering into the swap that "tips the balance" toward major participant status has been properly allocated in investment management agreements. (much of this paragraph is sarcasm - we know it is not lost on you).

Positions of Affiliated Entities

So, when do affiliated entities need to aggregate their swap and SBS positions? In a parent-subsidiary situation, where parent is majority owner (not 100% ownership, but simply majority), the swaps and SBS should be attributed to the parent on the basis that the parent is the beneficiary of the transaction. Comments sought as to which entity - parent or sub - should have responsibility for capital, margin, business conduct and other regulatory requirements that apply to major participants. 

Inter-Affiliate Swaps

Here is the Regulators had to say.

[W]e preliminary believe that when a person analyzes its swap or SBS positions under the major participant definitions, it would be appropriate for the person to consider the economic reality of any swaps or SBS it enters into with wholly owned affiliates, including whether the swaps and SBS simply represent an allocation of risk within a corporate group. [Footnote omitted] Such swaps and SBS among wholly-owned affiliates may not pose the exceptions risks to the U.S. financial system that are the basis for the major participant definitions.

Interested readers should look at the variety of opportunities to comment. Too numerous too mention in this overview, but worth a read (and possibly a comment letter) if you are interested in this topic.

Legacy Portfolios

The issue was identified, but no express position was articulated. Just invitations for comments.

Registered Investment Companies, ERISA Plans, Broker-Dealers, FCMs and SWFs
 

The general issue flagged for consideration was whether these different types of otherwise regulated entities should be excluded, conditionally or unconditionally, from the major participant definitions. Comments sought.

That's all folks!

Good afternoon. Good reading. TSR. 

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This is the 11th of a multi-part series on a December 7th rule proposal (75 Fed Reg 80174) by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, and eligible contract participant.

In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively. Specifically, we turn our attention to two separate issues under the rule proposal:

1) The implementation standard, reevaluation period and minimum duration of major participant status under CFTC Rule 1.3(qqq) and SEC Exchange Act Rule 3a67-7; and

2) Limited purpose designations for different major categories of swaps and SBS under CFTC Rule 1.3(qqq)(2) and SEC Exchange Act Rule 3a67-1(c).

But, first, our Prologue.

Prologue: We Were Right, We Were Wrong.

Yes, Pittsburgh is in the AFC Championship Game - having beat Baltimore on Saturday. Beating Baltimore feels good no matter what time of the season it is. It feels really good in the playoffs. We were right about that.

No, the AFC Championship Game is not in Gillette Stadium vs. the Pats - it is in Pittsburgh vs. the Jets (and we LOVE that). Watching New England lose feels good no matter what of the season it is. It feels really, really good in the playoffs. Yet, we have to admit, that we missed that call and doubted the Jets.We were wrong about that.

I'VE GOT A FEELIN', PITTSBURGH'S GOIN' TO THE SUPERBOWL

And you will not hear another word about the topic...until the next posting.

Implementation Standard

An unregistered entity that meets the major participant criteria as a result of its swap or SBS activity in a fiscal quarter will not be deemed to be a major participant until the earlier of

1) the date on which it submits its complete application for registration; or

2) two months after the end of that quarter.

It is that simple.

Reevaluation Period

The Regulators have proposed a reevaluation period for entities that meet one or more of the applicable major participant thresholds by a modest amount. This reevaluation period was raised in response to concerns by industry participants over the possibility of an entity qualifying as a major participant due to an unusual event, such as unexpected and unusual levels of volatility. Here is how it works:

IF an unregistered entity exceeds any applicable major participant test / threshold in a fiscal quarter by 20% or less,

THEN, it will only be subject to registration and regulation as a major participant if that entity exceeds any of the applicable daily average thresholds in the next fiscal quarter.

It is that simple.

Minimum Duration of Major Participant Status

Once an entity is deemed to be a major participant (i.e., on the basis of any of the three tests), it will retain that regulated status for a minimum of four quarters. In other words, once regulated, an entity will need to not exceed the applicable thresholds for four consecutive quarters after registration as a major participant, in order to "de-register" (our word, not the Regulators). The intended effect of this proposed rule is to avoid entities moving in and out of regulated status as a major participant on a rapid basis.

It is that simple.

Limited Purpose Designation

The definitions of "major swap participant" and "major security-based swap participant" provide that a person may be designated as a major participant for one or more categories of swaps or SBS without being classified as a major participant for all categories (see CEA Section 1a(33)(C) and Exchange Act Section 3(a)(67)(C)).

So, the Regulators have proposed that major participants who engage in significant activity with respect to only certain categories of swaps or SBS may apply for relief with respect to other categories of swaps or SBS from certain requirements applicable to major participants. In other words, a major participant can seek the status of "limited purpose designation," if it limits its activities in respect of swaps or SBS to certain types, classes or categories of such instruments.

It is that simple.

Good day. Good reading. TSR

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This is the 10th of a multi-part series on a December 7th rule proposal (75 Fed Reg 80174) by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, and eligible contract participant.

In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively. Specifically, we turn our attention to CFTC Rule 1.3(vvv) and SEC Exchange Act Rule 3a67-6, which defines the terms "financial entity" and "highly leveraged" for purposes of the third major participant test.

Prologue: I'VE GOT A FEELIN'....

PITTSBURGH'S GOIN' TO THE SUPERBOWL! Kick-off to the Pittsburgh vs. Baltimore AFC Playoff game is in about 5 hours. I may be blinded by my loyalty, but I say we take this game and then go to New England next and hand the expected Champs a headache in the AFC Championship game. This will be a great football day in Pittsburgh - cold, cloudy and snow. Perfect weather for knocking the tar out of the Balt Birdies (a.k.a., you can take the team out of Cleveland, but you can't take the dirt out of the team).

P.S. - If the Steelers lose today, then only those of you who have looked at this on Saturday, January 15th will know that I boldly called this wrong. Why? Because we WILL expunge the record.

The Third Test: Highly Leveraged Financial Entity With a Substantial Position in a Major Category of Swaps

As you may recall from an earlier posting, there are three different statutory tests that define a major participant  (see Part 5 of this multi-part series). Of concern to this posting is the third test, which subject any "financial entity" to registration and regulation as a major participant if that entity:

1) is not subject to capital requirements established by an appropriate Federal banking agency;

2) is "highly leveraged relative to the amount of capital" that it holds; and

3) maintains a substantial position in major category of swaps or SBS (Reminder -see Part 7 and Part 6 of this multi-part series for a discussion of "substantial position" and "major category of swaps / SBS," respectively).

 As an aside, I am really enjoying this cold winter day - chamois Field & Stream shirt and Aussie Emu boots - feeling a bit like the Mr. Rogers of the derivatives blogosphere...

So, come on neighbors  - let's take a closer look at the proposed definitions for the teams "financial entity" and "highly leveraged."

Financial Entity: What It Is Not

We will begin with an apophatic statement (with all respect for the normal and customary theological venue in which apophatic analysis is used).

The term "financial entity," as used in the third major participant test, does NOT include a financial entity that is subject to capital requirements established by an "appropriate Federal banking agency." The term an "appropriate Federal banking agency" is defined in Section 1a(2) of the Commodity Exchange Act and Section 3a(72) of the Securities Exchange Act (as added by Sections 721 and 761, respectively, of Dodd-Frank) as any of the following:

Comptroller of Currency
Board of Governors of the Federal Reserve
Federal Deposit Insurance Corporation
Director of the Office of Thrift Supervision
Farm Credit Administration

In other words, if you are a financial institution whose capital requirements are set by these agencies, then you do not need to concern yourself with the third test.

Financial Entity: What It Is

Since there is no explicit definition of "financial entity" in the context of the third test, the Regulators have proposed using the definition of the term "financial entity" in the end user exception to the central clearing mandate. The use of that definition means that any of the following entities will be financial entities for purposes of the third test.

Swap / SBS dealers
Major swap / SBS participants
Commodity pool (as defined in Section 1a(10) of the CEA)
Private fund (as defined in Section 202(a) of the Investment Advisors Act)
Employee benefit plan (as defined in paragraphs (3) and (32) of ERISA)
Person predominantly engaged in activities that are in the business of banking or financial in nature (as defined in section 4(k) of the Bank Holding Company Act)

The end-user exception, in general, and this definition, in particular, will be the subject of another posting that will be released within the next few days - so not  too much more on the topic for now. Rather, it is sufficient to note that the end-user exceptions definition has been modified for purposes of the third test to avoid circularity (e.g., for purposes of "major swap participant," the meaning of financial entity would not encompass any "swap dealer" or "major swap participant," but would encompass "SBS dealers" and "major SBS participants";  same idea for major SBS participant, financial entity would not encompass SBS dealer or major SBS participant, but would encompass swap dealer or major swap participant).

 Highly Leveraged

The Regulators have proposed two possible thresholds - total liabilities to equity in excess of 8:1 or 15:1 - that we now explore in greater detail. 

The 15:1 Threshold -The 15:1 test is based upon the predilection of the Regulators for Bacardi 151 over other types of rum - that was a joke designed to see if you are paying attention. The truth is that the 15:1 test is based upon a provision in Title I of Dodd-Frank that requires certain banks and non-bank financial companies to maintain a debt to equity ratio of no more than 15:1, if the Financial Stability Oversight Council determines that the company "poses a grave threat to the financial stability of the Unites States and that the imposition of such requirement is necessary to mitigate the risk that such company poses to the financial stability of the United States" (Section 165(j)(1) of Dodd-Frank). The Regulators are asking whether a higher standard may be more appropriate, since the entities in question presumably do not pose the same degree of threat to the financial stability of the U.S.

The 8:1 Threshold - This more conservative threshold is based upon the idea that the financial institutions exempt from the definition (i.e., those institutions whose capital requirements are set by an appropriate Federal banking agency) tend to have leverage ratios of approximately 10:1 and 8:1 is pretty close to 8:1 (the words "pretty close" were not in the December 7th release, but that is "pretty much" the logic proffered). 

Regardless of which threshold is ultimately used, a financial entity would measure its total liabilities and assets:

1) At the close of business on the last business day of the applicable fiscal quarter;

2) On the basis of U.S. generally accepted accounting principles (GA    AP - that was a pun, get it, there was a gap in the word GAAP - knew it would not be lost on our readership) or, if the entity files Forms 10-Q or 10-K with the SEC, the manner used for purposes of the financial statements included with those filings.

Comments, comments, comments...

The Regulators have identified several topics on which they are seeking comments, including:  

• The merits of the 8:1 and 15:1 standards
• Whether a risk-adjusted leverage ratio should be used and, if so, how it should be calculated
• Whether the leverage ratio should be revised to require that the amount of potential future exposure (see Part 7 of this multi-part series)  be combined with total liabilities for purposes of comparison with the equity level
• Whether there is an opportunity for gaming or evasion as a result of the quarter-end test
• Whether additional guidance is needed to prescribe how separate categories of entities calculate leverage

Who says the rule proposals aren't exciting?

Good afternoon. Good reading. TSR

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This is the 9th of a multi-part series on a December 7th rule proposal (75 Fed Reg 80174) by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant.

In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively. Specifically, we turn our attention to CFTC Rule 1.3(uuu) and SEC Exchange Act Rule 3a67-5, which sets numerical parameters to determine whether an market participant's swap positions create "substantial counterparty exposure," such that such participant will be registered and regulated as a major swap or major security-based swap participant.

Prologue: How Many Days Until Spring?

In 2011, spring begins on March 20th (at least for those of us on the wrong side of the equator this time of year). So, that means 69 days until spring. You may ask - What does that have to do with Dodd-Frank? The answer, of course, is nothing - but, there is a connection between the first day of spring and this posting...READ ON AND SEE IF YOU CAN FIGURE IT OUT. Back to the salt mines!

FYI: According to the American Heritage Dictionary of Idioms, the origin of that saying is the Russian practice of punishing prisoners by sending them to work in the salt mines of Siberia. TSR's editor studied Russian history, so found himself amused (but not surprised) by this grain (pun intended) of idiomatic history.)

The Second Test: Substantial Counterparty Exposure

As you may recall from an earlier posting, there are three different statutory tests that define a major participant  (see Part 5 of this multi-part series). Of concern to this posting is the second test, which subjects any person whose swaps "create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets"  to registration and regulation as a major participant.

If you want to understand how the 2nd test works, you need to understand how the 1st test works (i.e, substantial position in a major category of a swap or a SBS). If you want to read how the 1st test works, go read Part 7 of this multi-part series, which was posted at TSR on December 21st.

Do you get the connection between our Prologue and this posting now (Hint: December 21st is 1st day of winter)?

REFRESHER: CURRENT PLUS FUTURE EXPOSURES

Or, more precisely, the 1st test was driven by the current uncollateralized exposure plus the potential future exposure  - sound familiar? And, again more precisely, current uncollateralized exposure limits were set at a daily average of $3 billion for rate or FX swaps and $1 billion for SBS and all swaps other than SBS. The limits were set on a category by category basis, since the 1st test is a category by category test. Then, a market participant would add its "aggregate potential outward exposure" to its current uncollateralized exposure to come up with an all-in limit. If in excess of $6 billion for rate swaps ($2 billion in all other categories of swaps and SBS), then registration required under the first test.

The 2nd test works the same way except:

1) No Categories: It is not applied on a category by category basis;

2) Swaps: The current uncollateralized exposure is set a a daily average of $5 billion current uncollateralized exposure or a combined current uncollateralized and potential future exposure of $8 billion across the entity's aggregate swap positions; and

3) Security-Based Swaps: The current uncollateralized exposure is set a a daily average of $2 billion current uncollateralized exposure or a combined current uncollateralized and potential future exposure of $4 billion across the entity's aggregate SBS positions.

In other words, this is the same analysis and discussion as the "substantial position" test - as discussed in the December 21st, Part 7 posting - with the thresholds raised to account for the fact that there is no category by category distinction made in the second test, the so-called "substantial counterparty exposure" test.

Good reading. Good night. TSR

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This is the 8th of a multi-part series on a December 7th rule proposal (75 Fed Reg 80174) by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant.

In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively. Specifically, we turn our attention to CFTC Rule 1.3(ttt) and SEC Exchange Act Rule 3a67-4, which implements the exclusion for positions held for hedging or mitigating commercial from the substantial position analysis under the first test of the major participant definitions.

Prologue: Lawyers Are People Too

Let's get this out in the open - it has been a couple of weeks since we put "Part 8" out onto TSR's blog page. In fact, Part 7 was posted on December 21st. Why? Because lawyers are people too - and, as such, we took time off for the holidays to spend time with our families, recharge and reflect on 2010 and 2011.

Furthermore,  it is possible to construct an argument that it has only been 5 days since our last posting. For purposes of this posting, The Swap Report has switched to the Julian Calendar from the Gregorian Calendar. If time zones can be arbitrarily drawn on the basis of geography, then why can't internet websites follow different calendars. So, for purposes of this posting we are following the Julian Calendar and today's date is December 26th - and to our Russian and Serbian portion of our readership we say Рождеством Христовым.

How about that for some creative lawyering? Ok...maybe lawyers are not deserving of the human label like everybody else...back to the task at hand.

Hedging and Mitigating Commercial Risk: The Major Participant Exclusion

As you may recall from an earlier posting, there are three different statutory tests that define a major participant  (see Part 5 of this multi-part series). Of concern to this posting is the first test, which subjects any person who maintains a "substantial position" in any of the major categories of swaps and SBS to registration and regulation as a major participant. However, the test excludes positions held for "hedging or mitigating commercial risk" from the substantial position analysis. Throughout the rest of this posting, we use the acronym HMCR to mean "hedging or mitigating commercial risk" - how liberating it is to write like this.

HMCR: The Underlying Regulatory Principle; Application to Financial Entities

According to the Regulators, the proposed exclusion for HMCR is premised on the principle that swaps or SBS necessary to the conduct or management of a person's commercial activities should not be included in the calculation of a person's substantial position. In this regard, the Regulators noted that the commercial nature of the person's underlying activity to which the swap relates - rather than the person's organizational status as for-profit, non-profit or government entity - is what determines whether or not a person's activity is commericial.  

Furthermore, the Regulators used the December 7th release as an opportunity to clarify that the they interpret the phrase HMCR consistently in the context of the end-user exemption from the central clearing mandate, the other context in which that phrase is used under Dodd-Frank. Although, unlike the exclusion from the first major participant test, the exemption from the central clearing mandate is only available to non-financial entities.  

HMCR: The Major Swap Participant Definition

A swap that is used to hedge or mitigate a person's business risk will qualify for the HMCR exclusion even if it does not constitute a hedge for accounting purposes or a "bona fide hedge" for purposes of a CFTC exemption from position limit requirements. However, a swap will not qualify for the HMCR exclusion if it held for a purpose that is in the nature of speculation, investing or trading. These are worth focusing on, since they ended up in a footnote in the December 7th Release (and everybody knows that all regulatory gems are in footnotes).

Speculation and Trading Do Not Qualify: A swap position is held for speculation or trading if it is "held primarily to take an outright view on the direction of the market, including positions held for short term resale, or to obtain arbitrage profits." Significantly, "swap positions that hedge other positions that themselves are held for the purpose of speculation or trading are also speculative or trading positions." Presumably, the term "other positions" means other swap positions, rather than any other trading position - such as a trading position in a security or a currency (so called "long" positions).

Investing Does Not Qualify: A swap position is held for the purpose of investing if it is "held primarily to obtain an appreciation in value of the swap position itself, without regard to using the swap to hedge an underlying risk."

As always, the Regulators welcome comments. Invitations were specifically extended on a couple of issues that we found noteworthy:

1) Whether swaps qualifying for the HMCR exclusion should be limited to swaps where the underlying is a non-financial commodity.

2) Whether rules should be applied at an industry level.

3) Whether rules that apply only to certain categories of commodity or asset classes are appropriate.

Commenters should address "policy and legal bases underlying their comments."

(Editorial Comment: With all due respect to the Regulators - and we genuinely mean that - Dodd-Frank is a policy not a law - prevent systemic risk and bank bail outs. Regardless of any person's view of those policies, there is a noteworthy incongruity in the requirement that commenters should discuss the "legal bases" to policy issues. We say, reap what has been sown, policy begets policy, etc.)

 HMCR: The Major Security-Based Swap Participant Definition

A security-based swap (SBS) will qualify for the HMCR exclusion if the position is "economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise," provided that such risks "arise from the potential change in the value of assets, liabilities and services connected with" the ordinary course of business of the enterprise."

The Economically Appropriate Standard:  Whether a reasonably prudent person would consider the SBS to be appropriate for managing the identified commercial risk.

To qualify under this standard, the SBS should not introduce "any new material quantum of risks" (translation: No over hedging) and should not introduce basis risk or other new types of risks (other than counterparty risks) necessary to manage the identified risk.

The policy behind the "economically appropriate" standard is to make the HMCR exemption available for SBS that pose limited risk to the market since the swap position offsets risks from the entity's commercial operations. The specific example cited by the SEC in the December 7th Release is the use of a SBS to manage receivables that arise out of the ordinary course of the entity's commercial operations.

Speculation and Trading Do Not Qualify: As was the case with swaps, SBS positions will not qualify for the HMCR exemption, if held for a purpose that is in the nature of speculation or trading (i.e. "held primarily to take an outright view on the direction of the market, including positions held for short term resale, or to obtain arbitrage profits.") Also like swaps, SBS positions will not qualify for the HMCR exemption if they hedge other positions held for the purpose of speculation or trading. 

Must Document Risks: To claim the HMCR exemption for a SBS position, a person must take the following steps:

1) Identify and document the risks being reduced by the position;

2) Establish and document a method for assessing the effectiveness of the SBS as a hedge; and

3) Regularly make that assessment.

These requirements can be found in paragraph (a)(3) of SEC Exchange Act Rule 3a67-4.

Examples of Qualifying HMCR Positions: Here are the examples provided by the SEC of qualifying uses of SBS positions.

1) Use of SBS to manage a customer's default risk in connection with the financing, lease, purchase or supply commitment of that customer (or supplier, as applicable) in respect of real property or a good, product or service.

2) Use of SBS to manage the default by a financial counterparty to different OTC derivative that is entered into for hedging or risk mitigation purposes.

3) Use of SBS to manage equity or market risk of an employee compensation plan, such as a stock-based comp plan.

4) Use of SBS to manage equity or market risk arsing from a reorg (merger, asset sale, etc.) that involves another party.

5) Use of SBS to manage counterparty risks related to loans the bank has made.

6) Offsetting positions to close out any of the foregoing.

 Good afternoon. Good reading. TSR.

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Michael J. McFarlin posted a good overview article yesterday at futuresmag.com entitled (with link) "Dodd Frank: Moving From Theory to Practice"

Good day. Good Reading. TSR

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Our Firm has prepared a Dodd Frank Update Chart that gives you electronic access to all Dodd-Frank Rulemaking initiatives - not just derivatives but all sixteen titles and topics - in one document. It is current as of December 19th or so and will be updated in the New Year and regularly thereafter.

Good morning. Good reading. TSR

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This is the seventh of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively.

This is a very long posting - not our fault - the Regulators made us do it that way.  But, it is a lot shorter than the discussion in the proposed rule and (we hope) should make your read of that discussion less cumbersome. Let us jump to the conclusion for you.

The Regulators are hunting for a very specific type of entity in the uncollateralized current exposure and aggregate potential outward exposure tests. The vast majority of those who expressed concerns about the major participant categories are likely to escape unregulated and will probably have minimal compliance burdens to demonstrate that they are not subject to regulation.

Prologue: They Made It Official

Another day, another rule proposal published in the Federal Register. For those of you who like to curl up to Fed Reg version of a rule, here is your link to 75 Fed Reg 80174, which is the Fed Reg version of the rule proposal that is the subject of this multi-part series.  Now, to the task at hand - and it is a substantial one...

Why Substantial Position Matters

 As background, there are three different statutory tests (see Part 5 of this multi-part series) in respect of the definition of a major participant. The phrase "substantial position" is an element of the first and third tests (first test = maintain a "substantial position" in any of the major categories of swaps and SBS; third test = highly leveraged, non-banking financial entity that maintains a "substantial position" in any of the major categories of swaps and SBS).

We answered the question, "What is a major category?" in Part 6 of this series. Now, we will delve into the wild world of substantiality.  

The Congressional Mandate

In Title VII, Congress mandated that the Regulators define the term "substantial position" at a level that is "prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States."  In issuing the rule proposal, the Regulators, in turn, endeavor to answer two questions that they believe are relevant to the discharge of their duties:

1) What types of measures should be used to identify the risks posed by an entity's swap or SBS positions?

2) For each of those measures, how much risk constitutes a "substantial position"?

The Regulators have answered these questions through the issuance of two new proposed rules - CFTC Rule 1.3(sss) and SEC Exchange Act Rule 3a67-3 - that use objective numerical criteria to set the thresholds at which OTC trading activity rises to the level of a substantial position, thus subjecting the entity to registration and regulation as a major participant. In particular, the Commissions are proposing tests with respect to:

1) Current Uncollateralized Exposure; and

2) Current Uncollateralized Exposure plus Potential Future Exposure.

If a position satisfies either test, then it will constitute a substantial position. Each test will, in turn, be considered in remainder of this posting.

Current Uncollateralized Exposure (The Uncleared Swap Test)

We call this the "uncleared swap test," since by definition it will never apply to a centrally cleared swap that is subject to mark-to-market margining. Here is why - in the words of the Commissions:

This test would account for the risk-mitigating effects of central clearing in the centrally cleared swaps and SBS are subject to mark-to-market margining that would largely eliminate the uncollateralized exposure associated with a position, effectively resulting in cleared positions being excluded from the analysis. (Emphasis Added.)

But, it is not simply uncleared, but uncollateralized current exposure that drives the analysis. In other words, the Commissions are proposing to set the "substantial position" threshold by reference to the sum of the uncollateralized current exposure, "obtained by marking-to-market using industry standard practices, arising from each of the person's positions with negative value in each of the applicable "major" category of swaps or SBS.

There are four key aspects to this test (described in chart below). Before looking at the factors, here are our high-level thoughts:

As a theoretical matter - and certainly from an operational perspective - we believe that there is a substantial (pun intended) gap between current capabilities of most market participants to perform the uncollateralized exposure test, as proposed and required by the rules.  However, given the thresholds that trigger regulation - average daily out-of-the money market exposure valued at $3 billion (swaps) or $1 billion (SBS) - and particularly  in light of the current levels of uncollateralized market exposure (i.e., given collateralization levels negotiated by parties to what will be the uncleared swaps), we think that the vast majority of derivatives market participants will not be subject to regulation as a major swap or SBS participant - so all of this may be a moot point - and we acknowledge that right out of the proverbial gates..

That is it for our thoughts - here is what the Commission is proposing.

 Current Uncollateralized Exposure PLUS Potential Future Exposure

 So, an entity starts by running the uncollateralized exposure test and then adding to that number what is called potential future exposure - an estimate of how much the value of an entity's swap or SBS positions in a major category may move against the entity over time. The test can be thought of as the inverse of similar bank capital tests, in so far as it uses bank capital standards but focuses on the risk that an entity poses to its counterparties rather than the risk faced by an entity. Thus, the term used to describe this exposure is "aggregate potential outward exposure" - for reasons discussed below, we think that most market participants will not be regulated as major swap or major SBS participants on the basis of this test.

The starting point of the potential future exposure test  - the aggregate potential outward exposure test - is the total notional principal amount of the outstanding swaps or SBS by category. We expect that you are nervous, but rest assured reasonable adjustments to notional amount are made:

• Increase to account for multipliers
• Decrease by type and term (for example, only 10% of notional counts for credit derivatives with term of 1 year or less and and 7% of term for precious metals of same term) 
• Exclude purchased options and cap CDS exposure at NPV of unpaid premiums for protection buyer
• Decrease notional of positions subject to central clearing and mark-to-market margining (reduction here is 80%)

In other words, on a category-by-category basis, the proposed rules seek to adjust the notional amount to account for and quantify the amount of future risk actually presented to an entity's counterparties if that entity does not live up to its obligations under the swaps or SBS. In deciding upon this approach, the Regulators specifically rejected the use of a value at risk or stress testing methodology, since those methodologies were too subjective and costly to implement.

Here are the numbers that you need to know to scale the significance of this.

$6 billion - For rate swaps (FX, interest), the substantial position threshold would be $6 billion in daily average current uncollateralized exposure plus aggregate potential outward exposure

$2 billion -   For all other major swap categories, as well as SBS, the substantial position threshold would be $2 billion in daily average current uncollateralized exposure plus aggregate potential outward exposure

And, a very useful quote from the Regulators also helps to scale the significance of this to any particular entity's derivatives usage (and, by extension, need to monitor for potential futures exposure):

In light of the amount of this threshold and the underlying risk adjustments, we [the Regulators] do not believe that an entity would need to calculate its potential future exposure for purposes of the test unless the entity has large notional positions. For example, in light of the proposed risk adjustment of 0.10 for credit derivatives, an entity that does not have any uncollateralized current exposure would have to have notional positions of at least $20 billion to potentially meet the $2 billion threshold, even before accounting for the discounts associated with netting agreements. If those swaps or [SBS] are cleared or subject to mark-to-market margining, the additional 20 percent risk adjustment would mean that the entity without current uncollateralized exposure would have to have cleared notional positions of at least $100 billion to possibly meet that threshold.

The Last Line

The Regulators are hunting for a very specific type of entity in the uncollateralized current exposure and aggregate potential outward exposure tests. The vast majority of those who expressed concerns about the major participant categories are likely to escape unregulated and will probably have minimal compliance burdens to demonstrate that they are not subject to regulation.

Oh yeah, that last bit - The Last Line - is a Jimmy Buffett song off of  the 1978 Son of a Son of a Sailor album (right on, said it and meant it, album) and a real good one at that. Here you go, for your reading pleasure...

So don't pay me no mind, I'm walkin' away
You'll see me again on some other day
You'll see me again, I'll be ready to go
And pour out my songs with my heart and my soul

Whoa oh oh (woe oh woe oh woe oh)
Whoa oh (woe oh woe oh woe oh)
It's come from behind
Now is the time
For the last line (last line)
Yes it's come from behind
Now is the time
For the last line (last line)
Ah the last line (last line)

Good reading. Good night. TSR 

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This is the sixth of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant," as defined in Commodity Exchange Act 1a(33) and 1934 Exchange Act 3a(67), respectively.

Prologue: OMG! Like "major" is so majorly overused in Title VII

Whoa. Like can you even believe how majorly overused the term "major" is in like the new swap regs? And, what is a minor swap participant anyway? Isn't it like illegal to trade swaps with minors in most states?

Why Major Categories Matter

As background, there are three different statutory tests (see Part 5 of this multi-part series) in respect of the definition of a major participant. The phrase "major category" of swaps or SBS is an element of the first and third tests (first test = maintain a substantial position in any of the "major categories" of swaps and SBS; third test = highly leveraged, non-banking financial entity that maintains a substantial position in any of the "major categories" of swaps and SBS).

Now that we have laid that background, what is a major category? The answer depends upon whether or not we are talking about swaps or SBS.

Major Categories of Swaps

Proposed CFTC Rule 1.3(rrr) designates four major categories of swaps:

1) Rate Swaps: Any swap primarily based on one or more reference rates (interest, currency exchange, inflation, monetary).

2) Credit Swaps: Any swap primarily based on instruments of indebtedness (indices of debt instruments, CDX, total return swap on a debt index).

3) Equity Swaps: Any swap primarily based on equity securities (indices of equity securities, total return swap on an index of equity securities)

4) Other Commodity Swaps: Any swap not included in the first 3 categories (agricultural, energy, metals, etc.)

Major Categories of SBS

Proposed SEC Exchange Act Rule 3a67-2 designates two major categories of swaps:

1) Security-based Credit Derivatives:  Any swap 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 of securities (CDS, total return swap on one or more debt instruments, debt swap, debt index swap, credit spread).

2) Other Security-based Swaps: Any swap that is not a Security-based Credit Derivative.

Good reading. Good night. TSR.  

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This is the fifth of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "major swap participant" and "major security-based swap participant" found in Commodity Exchange Act Section 1a(33) and 1934 Exchange Act Section 3(a)(67), respectively.

Prologue: The Name of These Regulated Entities Is a Substantial Annoyance

Let us start out by admitting that we are getting worked up over nothing - understood. But, this is our blog and we have every right to hop onto the soap box about as mundane a topic as statutory nomenclature - so, here it goes...

What the he** were Messrs. Dodd and Frank thinking when they named this new class of regulated market participant a MAJOR swap / SBS participant (emphasis added)? Doesn't SUBSTANTIAL just make a whole lot more sense? If - and we know that this is a might big if, but - if the Monty Python gang were to ever do a Dodd-Frank skit, this definition just might make the cut.

Ok. Thanks; feeling better now. Onto the substance of this posting.

The Statutory Definition: The Foundation of the December 7th Proposal

A hallmark of Title VII is the creation of an entirely new regulatory architecture that applies to entirely new classes of regulated market participants - dealers and major participants. In fact, Dodd-Frank regulates dealers and participants in roughly the same manner through the application of registration, margin, capital, business conduct and other regulatory requirements on the affected party. In the first three parts of this multi-part series, we discussed the proposed refinements to the definitions of swap dealer and SBS dealer under the December 7th joint rule proposal issued by the SEC and the CFTC. This part of our series is the first of several that focuses on the refinements to the definition of "major swap participant" and "major SBS participant," which are defined by the relevant provisions of Dodd-Frank as any person that satisfies any of three alternative tests:

First Test: Substantial Position in Major Category - A person that maintains a "substantial position" in any of the "major" categories of swaps or SBS will be regulated as a major participant under the first test. The Regulators define what constitutes a major category. The statutory definition contains two exclusions from this test. First, "positions held for hedging or mitigating commercial risk" do not count for purposes of the first test. Second, positions maintained by an employee benefit plan for the primary purpose of hedging or mitigating the risks directly associated with the operation of the plan, also do not count for purposes of this test.

Second Test: Substantial Swap / SBS Exposure Could Adversely Affect on U.S. Market  - A person will be a major participant if its outstanding swaps or SBS create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets."

Third Test: Highly Leveraged Financial Entity Maintains a Substantial Position in Major Category - A financial entity will be a major participant if 1) it is highly leveraged relative to the amount of capital such entity holds, 2) is not subject to the capital requirements established by a U.S. banking regulator, and 3) maintains a substantial position in swaps or SBS for any of the major categories of swaps or SBS.

Congress directed the Regulators to define "substantial position" at a level determined to be "prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States." In other words, the major participant definitions focus on the market impacts and risks associated with an entity's swap and security-based swap positions.

The Regulatory Proposal

The December 7th joint rule proposal further defines the major participant by addressing:

(a) the "major" categories of swaps and SBS;

(b) the meaning of "substantial position";

(c) the meaning of "hedging or mitigating commercial risk";

(d) 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

(e) the meanings of "financial entity" and "highly leveraged."

Additionally, the Regulators have proposed what they describe as a "daily average methodology" that serves several purposes. First, the methodology will  identify whether a participant meets any of the three definitional tests. Second, it will provide for a reevaluation period for entities that cross the threshold of the relevant daily average by a small amount. Third, the methodology will provide for a a minimum length of time before a person may no longer be deemed a major participant.

We will explore these and other aspects of the December 7th proposal in the next several series of this multi-part blog.

Good reading. Good night. TSR.

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This is the fourth of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of refinements to the definition of "eligible contract participant," as defined in Commodity Exchange Act Section 1a(18) [as redesignated by Section 712 (a)(9) of the Dodd-Frank Act, so stop looking for Section 1a(12) - been there, done that, still do that].

Prologue: The Good Old Days

Back in the good old days, to be an ECP was something special. You walked with a little bit of a swagger, knowing that the really ugly stuff in the Federal commodities and securities laws just didn't apply to you. Well, the good old days are gone forever. At Section 2(d) of the Commodity Exchange Act - the statutory site (we meant to use an "s" instead of a "c" - bear with us) of the key former regulatory escape valves (i.e., former Sections 2(d),(e),(g) and (h)  - now stands a central clearing mandate (to some in the really geeky corners of the financial markets, this whole thing conjures up "Park51"-like imagery). Yuck...so what good is the eligible contract participant definition in the post Dodd-Frank world, anyway?

The Purpose of the ECP Definition in a Post Dodd-Frank World

Long and short - if you ain't an ECP, you ain't a counterparty. Let us explain in more conventional terms. Dodd-Frank makes it unlawful for a party that is NOT an ECP (a "non-ECP") to enter into a swap or a SBS outside of a futures or securities exchange, respectively. Furthermore, if a non-ECP enters into a SBS, then Dodd-Frank requires that a registration statement for the product be in effect. Conversely, this opens the doors for a retail market in the U.S. for swaps and SBS, since it means that non-ECPs can trade swaps over futures and securities exchanges.

(EDITORIAL NOTE: We say "swaps to the people" - we are sure that this is what Messrs. Dodd and Frank had in mind when they drafted Sections 723(a)(2) and 763(e) of their joyaux de l'art Congress-ique. Who knows - maybe Billy Joel is right, "You know the good old days weren't always good, And tomorrow ain't as bad as it seems." )

Rule Proposal: Amend the Definition of Swap Dealer and SBS Dealer

The Regulators are proposing to further define the term ECP to include swap dealers, major swap participants, SBS dealers, and major SBS dealers.

(EDITORIAL NOTE:  Congress did not add the new regulated categories (dealers/participants) to  the definition of ECP. So, it seems to us that they are "non-ECPs"...mmmm....maybe THAT is what those sneaky Senators had in mind.)

Relationship Between Retail FX and ECP Status in Context of a Commodity Pool

A small part of our readership base has a large interest in this. So, unless you care about it, gloss over it; but, if you have an interest in Retail FX, then keep on reading...

Before Dodd-Frank, a commodity pool was an ECP if it had $5 million in total assets and was operated by a CPO regulated as such under the Federal commodities laws. There WAS no requirement  that each pool participant be an ECP.  It mattered not whether it was a pool that traded futures contracts on retail foreign currency transactions of the type described in CEA sections 2(c)(2)(B) or (C) (this latter category of underlying, "retail forex" and any pool trading such instruments a "Retail Forex Pool").

After Dodd-Frank, every participant in a Retail Forex Pool must qualify as an ECP, in order for the pool itself to be an ECP (see clause (A)(iv) of Section 1a(18) of the Commodity Exchange Act, which is the ECP definition). 

Further, in the December 7th rule proposal, the Regulators propose a look through to the composition of any funds that, in turn, invest in a Retail Forex Pool. And, "any funds" means "any funds." In other words, a Retail Forex Pool will not be able to qualify as an ECP under clause (A)(iv) of the ECP definition if there is a non-ECP participant at any investment level (1st tier, 2ND tier, 3rd tier, 4th tier, ad nauseum, which our spellchecker believes to be ad museum). So, if not an ECP, then a non-ECP and if a non-ECP, then no access to SEFs and no access to bi-lateral trades (i.e., a Retail Forex Pool can only access the FX derivatives markets by trading FX futures through a futures exchange).

That's it. Next up...MAJOR SWAP PARTICIPANTS AND MAJOR SBS PARTICIPANTS. We know...the suspense is killing you.

Good day. Good reading. TSR

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This is the third of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of several miscellaneous items related to the definitions of  "swap dealer"  and "security-based swap dealer:"

1) Designation as a dealer for certain types of swaps; and

2) Interpretative Issues

a) Affiliates

b) Aggregators

c) Physical Market Participants

d) Electricity Generation and Transmission

But, as always, let's set the theme of the posting - our prologue.

Prologue: To Be Bit to Death by Ducks

We almost skipped these miscellaneous because, well, writing about them is like being bit to death by ducks. Hopefully, we have done this in a way that makes the issues more manageable for our audience.

Designation as a Dealer for Certain Types of Swaps and SBS

Title VII provides that a person may be designated as a dealer for one or more types of swaps or SBS without being considered a dealer for other types of swaps or SBS. Never one to miss the opportunity to further complicate, Congress made this a permissive standard, rather than a mandate. 

To implement the statute, the Regulators are proposing two new rules - clause (3) of CFTC Rule 1.3(ppp) and clause (c) of SEC Rule 3a71-1. In essence, a firm will be regulated as a dealer  for any type of swap or SBS entered into by that person as a dealer, but may seek limited designation status (i.e., not be a dealer for non-dealer activity in respect of other swaps and SBS).  That all sounds logical to us.

CFTC's Suggested Application to Physical Commodity Firms - Interesting note for readers that are physical commodity firms or other types of non-financial entities. In recognition of the fact that these firms may conduct swap dealing activity through an unincorporated business unit or division, the CFTC is proposing that the swap dealer requirements apply to swap dealing activities of the business unit but not to swap activities in other parts of the entity. That seems logical to us. But, the SEC did not sign on to this standard in respect of SBS, although that same general logic could apply to SBS - that does not seem logical to us.

Interpretative Issue #1: Affiliates

A trading desk or discrete business unit that is NOT a separately organized legal person is NOT the regulated dealer; rather, the legal person (i.e.,. corporation or, more colloquially, the firm) of which it is a part is the regulated dealer.

The indelible marks of dealing are holding oneself out as a dealer or being commonly known as a dealer. In the view of the Regulators, entering into transactions with affiliates (i.e., other legal persons under common control, such as "so-called" brother-sister companies) does not bear the imprint of these marks, unless the inter-affiliate trades are being entered into to avoid regulation as a swap or SBS dealer. (THE FOLLOWING IS NOT LEGAL ADVICE AND YOU SHOULD SEEK GUIDANCE OF LEGAL COUNSEL SHOULD YOU HAVE ANY QUESTIONS ABOUT YOUR FACTS AND CIRCUMSTANCES: As a general rule, the Regulators do not like the structural equivalent of three card monte (or Les Trois Perdants for the erudite street thieves in our readership base.)

Interpretive Issue #2: Aggregators

We LOVE the term "aggregator" at TSR. This is what it is all about::

A person, such as a co-op or a mid-market bank, enters into swaps  with other parties in order to "aggregate" the swap positions of the other parties into a larger size position for better pricing and/or more efficient execution in the derivatives markets.

The Regulators want to know what to do with aggregators and how to apply the de minimis exemption to their activities.

Interpretive Issue #3: Physical Market Participants

The Regulators want to know of any special considerations or accommodations that should be made for the markets in physical commodities such as oil, natural gas, chemicals and metals, as a result of the complexity and variation in those markets.

Interpretive Issue #4: Electricity Generation and Transmission

The Regulators want to know of any special considerations or accommodations that should be made for dealing activities of participants in the generation and transmission of electricity.  (For any non-profit, public power systems out there, the Regulators really want to hear your thoughts in respect of considerations arising from section 201(f) of the Federal Power Act).

Kicking the ducks from our ankles, we remain faithfully at your service.

Good day. Good reading. TSR

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This is the second of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators' rule proposal in respect of the exemptions and exclusions from the terms "swap dealer"  and "security-based swap dealer" (as always, alliteration intentional).

Now, let's suppose that you used the analytical tool that we presented in Part 1 of this series and determined that your firm does, in fact, engage in some level of swap or SBS dealing activity. What next? Simple - ask two questions:

How much swap or SBS dealing activity is it - a de minimis amount or something more than that?

If your firm is an insured depository institution, is the swap dealing activity being carried out in connection  with a loan that your firm originated? (This question is NOT relevant to SBS dealing activity.)

We discuss these two issues in greater detail below - but, first, our prologue.

Prologue: The "a.k.a" of This Posting

Yeah, we deal...gotta meet quarterly numbers somehow......but it is only a little bit or in certain situations...

That was almost the title of this posting. But, the marketing folks who keep us honest caution -  "Use boring titles as a courtesy to your readers who may be searching for key words - the title of a blog posting is NOT a forum for your slightly off and potentially offensive attempt at humor." Fine, we say - we will play by some rules...back to the substantive stuff.

EXEMPTION FOR DE MINIMIS SWAP DEALING ACTIVITY

Title VII of Dodd-Frank adds provisions to the commodities and securities laws - Section 1a(49)(D) of the Commodity Exchange Act and Section 3(a)(71)(D) of the Securities Exchange Act of 1934 -  that require the Regulators to exempt any person from substantive regulation as a dealer who "engages in a de minimis quantity of swap or SBS dealing activity with or on behalf of its customers." In order to implement exemption, the Regulators have two new rules - clause (4) of CFTC Rule 1.3(ppp) and 1934 Act Rule 3a71-2.

The theory behind the exemption from the perspective of the Regulators? 

"[T] he exemption should apply only when an entity's dealing activity is so minimal that applying dealer regulations to the entity would not be warranted."   

The approach taken in the new rules?

Establish the following bright-line tests (referred to in the release as "factors") measured over the prior 12 months that will allow a market participant to determine whether or not its dealing activity is de minimis (and not subject to substantive regulation):

1)   LIMIT ON AGGREGATE EFFECTIVE NOTIONAL AMOUNT - The aggregate effective notional amount, measured on a gross basis, of swaps or SBS entered into over the prior 12 months does not exceed:

a) $25 million with respect to trades entered into with "special entities" (i.e., Federal agencies, states, state agencies and political subdivisions (cities, counties, municipalities), employee benefit and governmental plans, each as defined under ERISA, and endowments); or

b) $100 million with respect to trades entered into with counterparties that are not  special entities.

This test will be measured on a "gross basis," which means without consideration of the market risk offsets associated with combining long and short positions. Also, the proposed aggregate effective notional test does not account for any collateral held by or provided by the entity, nor any other risk mitigating factors (such as guarantees or set off provisions across multiple relationships).

2) LIMIT ON NUMBER OF COUNTERPARTIES - Over the prior 12 month period, the entity may not have entered into swaps or SBS as a dealer with more than 15 counterparties (other than SBS dealers). Counterparties that are members of a group of an "affiliated group" (i.e., entities under common control and reporting financials on a consolidated basis) will count as 1 counterparty. 

3) LIMIT ON NUMBER OF SWAPS - Over the prior 12 month period, the entity may not have entered into more than 20 swaps or SBS as a dealer - this is applied at the "Transaction" level, rather than at the master trading agreement level. In other words, 10 swaps entered into under an ISDA Master Agreement count as 10 trades, not one trade. Also, an amendment does not count as a swap if the "underlying item remained substantially the same."

Finally, and this is important so we are going to emphasize it, a firm will need to satisfy all of these tests in order to qualify for the de minimis exemption  - fail one test, you can not qualify.

EXCLUSION FOR SWAPS IN CONNECTION WITH ORIGINATING A LOAN

The definition of swap dealer added by Title VII excludes an insured depository institution  to the extent that it offers to enter into a swap with a customer in connection with originating a loan to that customer. NOTA BENE - the definition of SBS dealer does NOT contain this exclusion.

As proposed by the CFTC, the rule includes a few noteworthy limitations:

1) FINANCIAL TERMS REQUIREMENT - The exclusion only applies if the swap is linked to the financial terms of the loan. So, for example, the exclusion may not apply if a lender offers a swap to its borrower customer  in order to hedge commercial risks that affect the borrowers ability to repay the loan, but are not a financial term of the loan - in the words of the CFTC itself, "even if the loan agreement requires that the borrower enter into such swaps or otherwise refers to them." (Editorial Comment: That just sounds like a bad idea. If the risk affects the borrowers ability to repay a loan, isn't it always a financial term.)

Hey, how does this apply to an IDI that is part of a loan syndicated?

You always ask such great questions. Thanks. It applies, as long as the swaps entered into by the syndicate member with the borrower are connected with the financial terms of the loans. (And, no, just because you are a syndicate member with IDIs does not make you an IDI.)

2) NO SHAM LOANS - As one would expect, the exclusion is not available if the loan is a  sham loan.

3) NO SYNTHETIC LOANS - The exclusion is not available if the loan is a synthetic loan, such as an LCDS or a loan total return swap, rather than a traditional cash borrowing.

The CFTC is seeking comments on these aspects of the exclusion, as well as a "contemporaneously" limitation that works like this: the exclusion would only apply to swaps entered into contemporaneously with the IDI's origination of the loan or, alternately, whether this exclusion should also apply to swaps entered into during the duration of the loan should be eligible for the exclusion. (Editorial Note: Another mark in the "what a terrible idea" column.)

Comments are due 60 days after Fed Reg publication, which as of the time of this posting did not happen.

Good morning. Good reading. TSR

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This is the first of a multi-part series on a December 7th rule proposal by the SEC and CFTC (the "Regulators") to further define several key terms in Title VII of Dodd-Frank: swap dealer, security-based swap dealer, swap participant, major security-based swap participant, and eligible contract participant. In this posting, we ruminate regarding the Regulators rule proposal in respect of the terms "swap dealer"  and "security-based swap dealer" (alliteration intended).

Prologue: Am I a Swap Dealer?

The inspiration for this posting is the 1960 classic children's story, "Are You My Mother?" by  P.D. Eastman. If you are not familiar with this story here is what happens - through no fault of its own, of course, a baby bird hatches at the precise moment  when its loving mother is off gathering food for her chick. So, the baby bird sets off to find mommy bird without knowing exactly what she looks like. So, as the name of the story suggests, the baby bird asks many different animate and inanimate objects - dog, cat, bulldozer, etc. - the following simple question: ARE YOU MY MOTHER?!?!

To the reader and the audience, the answer is quite obvious - a bird is not a dog; or a cat; or a bulldozer! To the baby bird, however, things could not be more confusing: it is new to this world and has no idea how it fits into it or even how it is different from or similar to a bulldozer, dog, cat, etc.

We recognize that we can not press the analogy too far, but you have to admit - despite the fact that everybody who has ever bought or sold a car understands who is the dealer and who is the customer - when it comes to a swap, things are not nearly as clear as they could be (and, for what it is worth, we at TSR think that the dealer analysis does not need to be much more complicated than the car dealer scenario). Given the uncertainty and ambiguity created by the definition of "swap dealer" and "security-based swap dealer" in Sections 721 and 761 of Dodd-Frank, respectively, one of the frequently recurring questions that we have gotten from a wide range of friends and clients is, "AM I A SWAP DEALER?" 

Definition of Swap Dealer and Security-Based Swap Dealer

Sections 721 and 761 of Dodd-Frank define the terms "swap dealer" and "security-based swap dealer." The December 7th releases proposes to further define these terms via two new rules - CFTC Rule 1.3(ppp) and SEC Exchange Act Rule 3a71-1. Both definitions begin with a recitation of the statutory definitions of the terms - a person is a dealer that engages in any one of the four following types of activity:

1) holding oneself out as a dealer in swaps or security-based swaps (SBS);

2) making a market in swaps or SBS;

3) regularly entering into swaps or SBS with counterparties as an ordinary course of business for one's own account; or

4) engaging in activity causing it to be commonly known in the trade as a dealer or market maker in swaps or SBS.

Against this backdrop of the definition, the December 7th proposing release discusses the types of activities that would cause a person to be a swap dealer or a security-based swap dealer, including differences in how those two definitions should be applied. To facilitate the application of this discussion to your business, we have created what we believe to be (with all due credits to the auto insurance company running the television ad that inspired us)...

 As a final matter, the Regulators expressly stated that dealing in swaps or SBS need not be an person's sole or predominant business activity in order for that person to be regulated as a swap or SBS dealer, "so long as a person engages in dealing activity that is not de minimis...which is the subject of Part 2 of our series.

Good reading. Good night. TSR

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Over the next several days, we will issuing a series of postings on the joint SEC/CFTC rule proposal released on December 7th and available here.

PURPOSE OF THE PROPOSED RULES

The purpose of the December 7th proposal was to further define key terms under Title VII of Dodd-Frank: swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, and eligible contract participant.

Comments are due in respect of the rule proposal 60 days after the date on which the proposal is published in the Federal Register. As of the date of this posting, the rule had not yet been published.

PURPOSE OF OUR MULTI-PART SERIES

The purpose of our multi-part series will be to provide our readers with an applied summary of the rule proposal - nota bene - applied summary (not your grandma's legal summary):

1) Applied: We will develop tools to help our readers apply the proposal to their business and, in so doing, determine whether or not a comment letter makes sense; and

2) Summary: Since our series is a summary, the material is a supplement to, rather than a substitute for reading the rule proposal.

Given the length of the rule proposal (179 pages single-sided, double spaced), we decided to prepare a multi-part series: too much of a good thing is a bad thing.

More to come soon.

Good afternoon. Good reading. TSR

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A primary goal of The Swap Report is to present complex information in a "user friendly" manner. To this end, we are providing our readers with a "Derivatives Regulatory Update" Download file (.PDF), which combines recent CFTC and SEC derivatives regulatory activity in one convenient .PDF file. The information included consists of:

1) A summary of the rule;

2) The related Dodd-Frank title to which the action relates (or a designation of not applicable, if a derivatives related item unrelated to Dodd-Frank);

3) A description of the nature of the regulatory action;

4) The citation to the publication in the Federal Register (in hyperlink form); and

5) The key dates for comments and / or effectiveness (if a final rule).

We decided to include links to proposals with open and expired comment periods, as clients and friends continue to inquire about both types of proposals. We hope that  you find the centralization of this information to be of value.

Good reading. Good day. TSR

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Overview

In a November 23rd Federal Register publication, the CFTC 1) proposed rules to establish registration requirements for swap dealers and major swap participants - collectively referred to in the rule proposal as "swaps entities" - and 2) sought comments in respect of those rules, as well as the extraterritoiral application of the swap dealer (SD) and major swap participant (MSP) registration requirements.

In this posting, TSR has summarized these proposed rules for our readers. We will do this once at the beginning - the proposed rules - some amendments to existing rules and some new - are CFTC Rule 3.10, CFTC Rule 3.2, CFTC Rule 3.21, CFTC Rule 3.31, CFTC Rule 3.33, CFTC Rule 23.21, CFTC Rule 23.22, and CFTC Rule 170.16. Now, we will not mention the rule cites again, since as always we are committed to providing you with a meaningful, applied summary.

Public comments on the proposed rules are due to the CFTC on or before January 24, 2011.

The Proposed Registration Process

The CFTC has proposed the application of the Commodity Exchange Act's existing registration scheme for other regulated entities - futures commission merchants, introducing brokers, retail foreign exchange dealers, commodity pool operators and commodity trading advisors - to swaps entities.

If adopted as proposed, the registration process for a swaps entity will involve the filing of two forms:

Form 7-R: A swaps entity would be required to file a CFTC Form 7-R on behalf of itself through an online registration system administered by the National Futures Association ("NFA"). The information required to be submitted on a Form 7-R is fairly basic, identifying information - entity's full legal name and form of organization, business address, busines records location, branch office location, principals, contact information and any disciplinary history. 

Form 8-R: The swaps entity would also be required to submit a Form 8-R to provide information to the NFA regarding the entity's "principals"- controlling directors or officers; 10% voting shareholder; or any other person that contributed 10% or more of the entity's capita). The information provided in  this form allows the NFA to conduct a background check to ensure that the entity's principals do not have a disqualifying criminal history or regulatory background.

The proposed rules would also establish a process for withdrawing from registration or correcting and updating information submitted on a previously filed Form 7-R or 8-R.

Timing of Registration Process: Phased Implementation

To implement the registration requirements in the least disruptive manner as possible, the CFTC is proposing what it describes as a "phased implementation" of the requirements. This approach is being taken to accomodate timing potentially conflicting timing issues under Title VII of Dodd-Frank:

1) No later than July 21, 2011, the CFTC must promulgate rules to provide for the registration of swaps entities; and

2) The CFTC is permitted to adopt  many of the regulatory and compliance requirements that will apply to swaps entities after July 21, 2011. (As background, these requirements were established by Congress pursuant to Section 4s of Title VII and, as a result, are referred to in the rule proposal as, the "Section 4s Requirements. " Generally, the requirements will directly and significantly affect many areas of a swap entity's operations, including capital and margin levels, daily trading requirements, business conduct standards, documentation standards, trading duties, retention of a chief compliance offer, and segregation of customer collateral.)

To reconcile the potential conflict, the proposed rules allow swaps entities to register as early as April 15, 2011 on a provisional basis, subject to the requirement that they timely establish compliance with the various Section 4s Requirements.

Extraterritorial Application of Swaps Entity Registration Requirements

Breathe easy (or not): no rules were promulgated - YET. However, comments were invited on extraterritorial applications of the swaps entity registration requirements. Specifically, the CFTC must determine the circumstances under which a person engaged in swap dealing activities outside of the U.S. will be required to register as a SD. (As a related aside, Societe General submitted a recent comment letter that may be of particular interest, if you are a non-U.S. bank that engages in swap dealing activities.) Of note, in this regard, is the statement that:

The [CFTC] generally would not require a person to register as a swap dealer if their only connection to the U.S. was that the person uses a U.S. regsitered swap execution facility, designated clearing organization or designated contract market in connection with their swap dealing activities, or reports swaps to a U.S. registered swap data repository. On the other hand, a person outside the U.S. who engages in swap dealing activities and regularly enters into swaps with U.S. persons would likely be required to registere as a swap dealer.

As we shared in our July 2010 teleseminar,  one starting point for the implementation of extraterritorial aspects of Dodd-Frank may be the registration standards summarized by the NFA in respect of a non-U.S. FCM, IB, RFED, CPO or CPA and in response to the question, "If my firm is not based in the United States, what requirements does it have?"

With respect to MSP registration, the landscape differs a bit - specifically, the definition of an MSP under Title VII is focused on the degree of risk that an entity's swaps pose to U.S. counterparties and the U.S. market. To this end the dirty words - interstate commerce - have reared their head. Here is what the CFTC had to say (and is requesting comment on):

[T]he analysis of whether a non-U.S. entity should register as an MSP would turn upon, among other things, swap positions with U.S. counterparties (including the use of a U.S. [ central counterparty] or that involve U.S. mails or any means or instrumentality of interstate commerce.

In short, that is a potentially broad application of the MSP registration requirement to non-U.S. entities. At a minimum, we believe that there are strong policy arguments to the effect that the interstate commerce standard should be modified by the fact that Section 2(i) of the CEA mandates that Title VII's provisions (includeing the registration requirements for swaps entities) shall not apply to activities outside the U.S. unless those activities "have a direct and significant connection with activities in, or effect on, commerce of the Unites States" (emphasis added). If not modified, then we are back to where we started - that is a potentially broad application of the MSP registration requirement to non-U.S. entities.

Regulatory Responsibilities

The proposal also requests comments on the division of responsibility for regulatory oversight as between the NFA and the CFTC. Which of the two should oversee which aspects of the Section 4s Requirements?

Comments Due By

January 24, 2011 - that is less than three months before the earliest permissible registration date of April 15, 2011 - wow, that's fast.

Good reading, good night. TSR

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Reminder: Public Meeting December 1st

 WHAT: CFTC to hold Public Meeting on Sixth Series of Proposed Rules.Topics  to be discussed

• Core principles and other requirements for designated contract markets;
• General regulations for derivatives clearing organizations;
• Information management requirements for derivatives clearing organizations;
• Reporting, recordkeeping and daily trading records requirements for swap dealers and major swap participants; and
• Further definition of “swap dealer,” “security-based swap dealer,” “major swap participant” and “eligible contract participant.

The Commission may also vote on a notice of future scheduled meetings to consider various proposed rules.

BENEFIT OF PARTICIPATING: Market participants will gain insight into the regulatory structure of derivatives clearing organizations, swap dealers, and major swap participants.

WHO MAY BE INTERESTED IN PARTICIPATING: Legal, compliance, treasury and risk management functions, as well as institutional client representatives (sales coverage), of

a) Swap dealers and major swap participants

b) Asset managers and their institutional clients

c) Energy and agricultural traders or physical commodity traders

d) Clearinghouses (i.e., DCO's and clearing agencies)

Bottom line: If you trade or deal in derivatives (or someday expect to trade or deal in derivatives), then you probably have an interest in the topics that will be covered by this roundtable since it will discuss the regulatory structure of swap dealers and major swap participants. 

DATE: December 1st

TIME: 9:30 a.m. - 5:30 p.m. EST

HOW TO PARTICIPATE (According to CFTC website):

Watch a live broadcast of the meeting via webcast on www.cftc.gov

OR Dial in at

US Toll-Free: 1-203-607-0666
(Non U.S.-Dial Information available at cftc.gov)
• Passcode: 1693567

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During a Title VII training session yesterday, I made the following statement: 

systemic risk is the new communism - it seems like everybody is seeing it everywhere.

I have made statement before and - to be honest - every time that I say it, it makes me laugh a little bit more than the last time that I said it. On the one hand, it is a ridiculous statement - and I recognize that. Yet, on the other hand, it is absolutely true - the Dodd-Frank Act could have just as easily been called the "Systemic Risk Management Act of 2010" or even - how about this - "The Hedging of Systemic Risk Act of 2010. " But, I digress...back to the main point...

As I sat down to my morning cup of coffee and stack of "today's" Title VII comment letters on the CFTC / SEC websites, I came across a November 2nd letter from James P. Hoffa, General President of the International Brotherhood of Teamsters, in which the following statement is made:

We [the Teamsters] are deeply concerned by the recent arguments made by financial industry groups that "commercial risks" should be defined to include financial risk where a commercial firm or a bank is hedging financial risk...If the Commission were to interpret the legislation as [the financial] industry groups have suggested, the effect would be that all swaps traded by non-financial entities would be exempt from clearing and trading requirements...

The Teamsters Union, [sic] urges you to reject the arguments made by the financial industry lobby in an attempt to maintain the opaque, unregulated over-the-counter derivatives market. We have seen the catastrophic effects on working families, businesses and the U.S. economy of this market without proper regulation and transparency, and we must not miss this opportunity to bring much needed reform....

Now, I suppose that one response to this letter could be something along the following lines:

"With all due respect, good Sir, that is simply not an accurate statement. Correct - in order to manage systemic risk, Section 2h(1)(A) of the Commodities Exchange Act, as added by Section 723(a)(3) of Dodd-Frank, added a central clearing and trading mandate. Yes, Section 2h(7) contains an exemption from that mandate for swaps that are used to hedge or mitigate commercial risk. BUT, that exemption is called the "end user exemption" because it is only available if the hedging party (or, commercial risk mitigating party, as it were) is not a "financial entity," which Section 2h(7) defines, in pertinent part, as person predominantly engaged in activities that are in the business of banking.

Yes, it is true that one of these financial institutions could enter into a swap with a real, dyed-in-the-wool manufacturer that is using the swap to hedge or mitigate its real, dyed-in-the wool commercial risks and, as a result, the swap be exempt from the clearing mandate - but, that has everything to do with the commercial end-user - even in the hypothetical situation where the financial institution is also using the swap to manage its commercial risk. 

Far from being a threat to "working families, businesses and the U.S. economy," a broad interpretation of "commercial risk" respects the policy objective of the Obama Administration and Congress - regulate in order to manage systemic risk. Why? Because a financial institution using swaps to hedge its financial risks is not the type of activity that creates SUBSTANTIAL systemic risk - which is what the "major swap participant" seeks to manage (say, why isn't it a "Substantial Swap Participant" anyhow?)."

But, I am not going to do that because, well, it seems a little bit over the top. I think that I will just make this observation

SYSTEMIC RISK IS THE NEW COMMUNISM - AND THE TEAMSTERS SEE IT EVERYWHERE.

Communism...Systemic Risk...a letter from the Teamsters...see, even you think it is funnier than when you first heard it.

Good night, good reading.

TSR

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WHAT: There is an Open Meeting scheduled for November 19th at 10:00 a.m. EST.

TOPICS TO BE DISCUSSED: As it relates to derivatives issues, the SEC plans to discuss:

1) Whether to propose new rules under Section 763(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act governing the security-based swap data repository registration process, the duties of such repositories, and the core principles applicable to such repositories; and

2) Whether to propose Regulation SBSR under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to provide for the reporting of security-based swap information to registered security-based swap data repositories or the Commission and the public dissemination of security-based swap transaction, volume, and pricing information.

WHO MAY BE INTERESTED: Given the diverse and large number of recent inquiries from our clients and friends about reporting of swap data, our instinct is that all derivatives market participants will have an interest in this. Obviously, aspiring swap data repositories should be tuned in, but really if you trade, deal or talk derivatives, this is worth tuning in.

HOW TO PARTICIPATE:

In-Person: The open meeting will be held in the Auditorium, Room L-002 at the SEC's headquarters building, 100 F Street, N.E., Washington, D.C.

Webcast: Before the meeting starts, we have been told that there will be a webcast posted to the SEC's Upcoming Events page.

By Phone: The dial-in information is not yet available, but we have been assured that it will be available soon (and expect to receive it this afternoon). When we have it, you will have it.

Good day. Good reading.

TSR

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 WHAT: CFTC to hold Public Meeting on Fifth Series of Proposed Rules. Topics to be discussed:

1) Swap data repositories

2) Real-time public reporting of swap transaction data

3) Protection of collateral of counterparties to uncleared swaps, and treatment of securities in a portfolio margining account in a commodity broker bankruptcy

4) Data recordkeeping

5) Issuance of an Advance Notice of Proposed Rulemaking involving Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies

BENEFIT OF PARTICIPATING: Market participants will gain insight into nuances of 1) swap reporting proposals, including the highly discussed "real time reporting requirement" and 2) insolvency issues that customers of a swap dealer can expect to face in the event of a dealer bankruptcy.

WHO MAY BE INTERESTED IN PARTICIPATING: Legal, compliance, treasury and risk management functions, as well as institutional client representatives (sales coverage), of actual and/or aspiring

a)  Swap dealers and major swap participants

b) Asset managers and their institutional clients

c) Commodity traders and brokers

d) Clearinghouses (i.e., DCO's and clearing agencies), especially those that intend to be dual registrants as a clearinghouse and swap data repository

e) Swap data repositories

f) Swap execution facilities (SEFs)

g) Independent-third party custodians who intend to hold customer margin in respect of uncleared swaps

BOTTOM LINE: If you trade or deal in derivatives (or someday expect to trade or deal in derivatives) or are a bank custodian that intends to service clients that trade or deal in derivatives, then you probably have an interest in the topics that will be covered by this roundtable, in general, and the dealer insolvency issues, in particular.   

DATE: November 19th

TIME: 9:30 a.m. to 12:30 p.m. EST

HOW TO PARTICIPATE (According to CFTC Website):

Watch a live broadcast of the meeting via webcast on www.cftc.gov

OR Dial in at

US Toll-Free: 1-877-951-7311
• Passcode: 5560205

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In January 2010, the Securities and Exchange Commission ("SEC") announced a new cooperation initiative intended to encourage and incentivize individuals and companies to cooperate with and assist the SEC in its investigations and enforcement actions. That initiative, which was characterized as a “potential game-changer” for the SEC’s Enforcement Division by its new director, Robert Khuzami, gave the SEC a new set of tools for its “enforcement toolbox”, including cooperation agreements, deferred prosecution agreements and non-prosecution agreements. These options, while employed by the Department of Justice, were not previously available in SEC enforcement matters. In addition to outlining those tools in a revision to the SEC’s Enforcement Manual, the Commission provided a policy statement detailing the factors the SEC considers when evaluating cooperation by individuals and by companies.

For more information, please read Sarah Wolff post on the Global Regulatory Enforcement Law Blog.

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Our review of the recent CFTC rule proposal relating to the "Prohibition of Market Manipulation" (Proposed CFTC Rules 180.1 and 180.2) and Advanced Notice of Proposed Rulemaking in respect of "Antidisruptive Practices Authority" (Section 747 of Dodd-Frank) left us at TSR feeling as if some market participant, some day may walk right into a "Gotcha" - you know how it would go...something along these lines.

Market Participant X puts on a trade and market conditions change, such that Market Participant X appears to have done something that it did not intend to do (or appears to have effected a market in one way or another) ; then along comes an inquiry and subsequent enforcement action from the CFTC - Gotcha! 

Then, we started to think to ourselves - imagination admittedly running out ahead of us - could this be another source of unintended consequences - ambiguity in trade enforcement regulations cause decreased liquidity (perhaps in some of the most illiquid markets) or even worse, in some paradoxical way, as the law in the area develops over time encourage (rather than discourage) market activity that may not have otherwise gained any traction (but for regulatory ambiguity that can then be exploited for profit)?

Well, we initially dismissed our gut reaction to these two Fed Reg items. We told ourselves - and dare say convinced ourselves - that  we must have been in a bad mood when we read that release, seeing economic ghosts that are not really there due to the myopic legal lens through which we tend to be viewing these rules. We would go back and look at them in a couple of days.

In the meantime, we came across this piece - The William Clayton Memorial Manipulation Rule - at The Streetwise Professor (aka, Dr. Craig Pirrong, Professor of Finance and Energy Markets Director of Global Energy Management Institute at The Bauer College of Business, University of Houston, who has written extensively on commodities market manipulation). 

We will let you form your own view Dr. Pirrong's piece - but, we'll just tell you this. Call us myopic, but we don't think that those are ghosts that we are seeing.

Good reading, good night. TSR.

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For anybody keeping track, that is 9 rules in 24 hours. So, we keep saying this but we mean it - more to come - and in the meantime...

The SEC Whistleblower Proposed Rules, Part 240 (contains Rules 240.21F-1 through 16 - 181 pages so beware) and a Press Release. Comments due The CFTC's version of the whistleblower rule will be discussed at the upcoming November 10th CFTC meeting, outlined here.

And, the long awaited SEC Proposed Rule 9j-1, which applies anti-fraud and manipulation provisions of U.S. Federal Securities laws in respect of security-based swaps (by way of example, single name CDS, single share equity TRS), etc. and a Press Release. Boy, there is something here to love or hate, depending upon your Window On The World (Jimmy Buffet, as you might have expected, covering a John Hiatt song in 2004 License To Chill release)

Here is a little sample of the SEC's proposal:

The proposed rule is intended to parallel the general antifraud provisions applicable to all securities, while also explicitly addressing the characteristics of cash flows, payments, deliveries, and other obligations and rights that are specific to security-based swaps

By targeting misconduct that is specific to the ways in which security-based swaps are structured and used, the proposed rule should help to prevent such fraudulent and manipulative conduct - without intering with or otherwise unduly inhibiting legitimate market or business activity.

 And a little sample of Mr. Hiatt's poetic contributions from Window On The World

In broad daylight that circus tent
Pulled up stakes
I don't know where it went
A close dark room with a busted vent
That's my window on the world.                        GOOD STUFF THERE, HUH??? (Hiatt, not SEC!)
 

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Reminder: Public Meeting November 10th

 WHAT: CFTC to hold Public Meeting on Fourth Series of Proposed Rules. Topics  to be discussed:

1) Registration of Foreign Boards of Trade

2) Registration of swap dealers and major swap participants

3) Implementation of the Whistleblower provisions of Section 23 of the Commodity Exchange Act

4) Establishing and governing the duties of swap dealers and major swap participants

5) Two proposed rules regarding the implementation of conflict-of-interest policies and procedures by futures commission merchants, introducing brokers, swap dealers and major swap participants

6) Designation of a chief compliance officer, required compliance policies and annual reports of futures commission merchant, swap dealers and major swap participants

BENEFIT OF PARTICIPATING: Market participants will gain insight into the registration and regulatory structure for swap dealers, major swap participants and futures commission merchants, as well as the extraterritorial jurisdictional issues related to foreign boards of trade.

WHO MAY BE INTERESTED IN PARTICIPATING: Legal, compliance, treasury and risk management functions, as well as institutional client representatives (sales coverage), of

a) Futures commission merchants, introducing brokers, swap dealers and major swap participants

b) Asset managers and their institutional clients

c) Energy and agricultural traders or physical commodity traders

d) Clearinghouses (i.e., DCO's and clearing agencies)

e) Swap execution facilities (SEFs)

f) Futures exchanges based outside of the U.S. and non-U.S. based traders

g) Anybody who aspires to be a CCO of an FCM, SD or MSP

h) Members of the bar who will bring whistleblower actions in respect of derivatives or defending derivatives industry stakeholders in such actions

Bottom line: If you trade or deal in derivatives (or someday expect to trade or deal in derivatives), then you probably have an interest in the topics that will be covered by this roundtable since it will discuss registration and governing duties of swap dealers and major swap participants. 

DATE: November 10th

TIME: 1:00 p.m. to 4:00 p.m. EST

HOW TO PARTICIPATE (According to CFTC website):

Watch a live broadcast of the meeting via webcast on www.cftc.gov

OR Dial in at

US Toll-Free: 1-877-951-7311 (Non U.S.-Dial Information available at cftc.gov)
• Passcode: 6960577

The Swap Report thanks Jennifer Dulski of Reed Smith for this reminder.

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Sometimes it feels like the regulators are on the offensive - 7 proposed rules in less than 24 hours. (In fairness, I am certain that some at the regulators feel that way about Congress.) Well, anyway, it is as it is. More to come on highlights from this flurry of rulemaking activity, but here is today's scoop.

1) The CFTC just proposed two new rules

2) 75 FR 67642  17 CFR Parts 1 and 30 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions

There is alot of market buzz about this proposal due to the possible restrictions on the use of money market funds for investment of client funds under CFTC Rule 1.25, as discussed at the October 26th public meeting. As a follow-up to that meeting, the CFTC has prepared a number of useful fact sheets and charts (including a really useful Rule. 1.25 chart).

3) 75 FR 67657  17 CFR Part 180 Prohibition of Market Manipulation

Again, there is alot of discussion on this proposal, as well. In short, Dodd-Frank represents a significant expansion to the CFTC's enforcement powers in respect of manipulative and disruptive trading - and this is the first proposal in respect of that expansion. Depending upon which way these rules go and the combination of the CFTC's disposition / receipt of adequate funding, enforcement issues will become an even greater source of concern for many market participants.

Good reading.

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The CFTC is soliciting comment in respect of five proposed rules published today (November 2nd) in the Federal Register. Comment due dates noted below

• 75 FR 67254
  17 CFR Parts 1 and 4 Removing Any Reference to or Reliance on Credit Ratings in Commission Regulations; Proposing Alternatives to the Use of Credit Ratings
  30 Day Comment Period (Due December 2, 2010)
  
• 75 FR 67258
  17 CFR Parts 15 and 20 Position Reports for Physical Commodity Swaps
  30 Day Comment Period (Due December 2, 2010)
   

• 75 FR 67277
  17 CFR Parts 39 and 140 Process for Review of Swaps for Mandatory Clearing
  60 Day Comment Period (Due January 3, 2011)
  
   
• 75 FR 67282
  17 CFR Part 40 Provisions Common to Registered Entities
  60 Day Comment Period (Due January 3, 2011)
  
   
• 75 FR 67301 
  17 CFR Chapter I Antidisruptive Practices Authority Contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act
  60 Day Comment Period (Due January 3, 2011)
   

Thought you'd want to know - be back with some thoughts later.

FOR OUR U.S. READERS, DID YOU VOTE? Get to it and good day.

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NOTICE AND REQUEST FOR COMMENTS FROM TREASURY

RE: Determination of FX Swaps and Forwards

Comments Due November 29, 2010

KEY POINTS

1) A hallmark of Dodd-Frank is the regulation of "swaps" by the CFTC. Among other things, Dodd-Frank mandates the central clearing and execution of swaps through derivatives clearing organizations and swap execution facilities (or exchanges), respectively.

2) The term swap is broadly defined under Section 721 of Dodd-Frank to include "foreign exchange swaps" and "foreign exchange forwards"

Dodd-Frank defines a  "foreign exchange swap" as 

a transaction that soley involves (A) an exchange of 2 different currencies on a  specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and (B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange

Dodd-Frank defines a "foreign exchange forward" as

a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.

3) Dodd-Frank authorizes the Secretary of the Treasury to make a written determination that foreign exchange swaps or foreign exchange forwards, or both, should not be regulated as swaps under the U.S. commodities laws (as amended, of course, by Dodd-Frank). Even if exempted by the Secretary, FX swaps and forwards will be subject to the reporting requirements under Dodd-Frank Act (including the interim rule that we discussed in our recent Q&A). 

4) In making this determination, the Treasury must consider certain factors enumerated under Dodd-Frank.

 ``(1) whether the required trading and clearing of foreign exchange swaps and foreign exchange forwards would create systemic risk, lower transparency, or threaten the financial stability of the United States;

``(2) whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by this Act for other classes of swaps;

``(3) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision,including capital and margin requirements;

``(4) the extent of adequate payment and settlement systems; and

``(5) the use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements.

4)  Treasury is soliciting comments on these factors, as well as any relevant comments to assist it in making this determination.

5) In soliciting comments, the Treasury has raised ten specific questions that can be found in the Notice.

6) One of the questions - Question 3 in particular - asks, "Are there objective differences between long-dated and short-dated foreign exchange forwards and swaps such that one class may be less suited to regulation as "swaps" under the CEA than the other?

7) We are amused - as you may recall, on October 14th we posted an entry entitled "Spot FX: Say What You Mean and Mean What You Say" - well, we thought about calling this posting "Foreign Exchange Forwards and Foreign Exchange Swaps: Say What You Mean and Mean What You Say."

So, here is a hint as to why: Re-read that piece, then think about the definition of a foreign exchange forward in the context of the Treasury's Notice, and ask yourself this question (which we raised in the Spot FX piece):

Everybody knows that spot FX means a forward period of two business days or less, right? Depends who you ask - some people say 2 days and some say 7 days.

And to that we add, which of these two OTC contracts should be exempt from regulation and why?

To paraphrase John "Hannibal" Smith (George Peppard) of the A-Team, "We love it when two postings come together."

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NO.  WHY?

Well, as explained by CFTC Commissioner Bart Chilton in the following excerpt from an October 25th speech , the answer is quite simple - BECAUSE NEITHER CONGRESS NOR THE CFTC INTENDS TO PUNISH END-USERS.

Congress did not have the intent of punishing end users when they passed the bill.  And, if there was any question, it was answered by Senators Dodd and Lincoln in a letter they sent to colleagues while the bill was in conference.  They also instructed us at CFTC and the SEC not to impose rules that would make hedging costlier.  Our goal is not to impose margin on hedgers or to regulate end users as swap dealers or major swap participants.  They can take advantage of the end-user exemption from the Act’s mandatory clearing requirement.  Whether swaps are used by those Nebraska farmers or by major airlines trying to protect themselves from potentially higher fuel costs, they will not face higher costs for their legitimate hedge activities.

What the law does require we regulators to do is to set rules for margin requirements for un-cleared trades.  But Congress has made it clear that the rules not require the imposition of margin requirements on the end user side that would punish those who are hedging their commercial risk.

BUT, IS IT THE INTENT OF CONGRESS AND THE CFTC THAT IS OF CONCERN TO MOST END-USERS WHEN IT COMES TO INCREASED HEDGING COSTS?

With all due respect to Comissioner Chilton and the hard-working staff of the CFTC tasked with regulating the commanding heights of the derivatives markets, Congressional and regulatory intent is not the concern. In fact, nearly two years, several end-user and dealer trade organizations have voiced concerns over the unintended consequences of what came to be known as the margin and capital requirements in Title VII of the Dodd-Frank Act.

In short, increased margin and capital requirements for dealers are a fact under the Dodd-Frank architecture - end-users understand that. And, as profit maximizing commercial enterprises, end-users also understand that they (as customers) will feel the consequences of increased margin and capital requirements one way or the other. End-users expect that their costs to implement hedging strategies will increase - regardless of whether or not that is the intent of Congress or the regulators.  

Finally, Commissioner Chilton's comments call to mind one other question -

WAS IT THE INTENT OF CONGRESS TO PUNISH OTHER DERIVATIVES MARKET PARTICIPANTS?

Of course not, as the Treasury Department informed us on June 17, 2009, the underlying policies the derivatives market regulatory reforms are to:

1) Reduce systemic risk:
2) Promote the efficiency and transparency of the OTC markets:
3) Prevent fraud, market manipulation and other abuses: and
4) Ensure OTC derivatives are not marketed to unsophisticated parties.

That's right - do forgive TSR for having lost sight of those policies.

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Here is your report from this morning's meeting - apologies upfront for length, but we wanted you to benefit from a full overview.

Next three meetings will be: November 10th, November 19th and December 1st.

OPENING REMARKS

All of the Commissioners expressed concern about lack of adequate funding. Several commissioners also indicated the significance of new manipulation and disruptive trade practice rules and enhanced enforcement authority. Sounds like there is definitely more to come in near future regarding silver markets and public’s concern over widespread manipulation in the markets. 

 STAFF PRESENTATIONS and COMMISSION APPROVALS

1) Part 40: How the CFTC approves the rules and new products of registrants

Division of Market Oversight gave this presentation. The proposed rules make changes to Part 40, which relates to CFTC review of proposed changes to registrant rules and products approvals. At a high level, the biggest change is timing: under the proposal, there is a 10 day initial review period for rule certifications (but not product certifications) during which the CFTC has a chance to determine if the proposal is novel or complex. If determined to be complex, then CFTC can extend the review period another 90 days and seek public comment. There is a presumption of approval at the end of the 90 day period, unless CFTC rule or public comments warrant otherwise.

This is different from current Rule 40 procedures, which provide for a 1 day self-certification period for both rule certifications and product certifications. The 1 day review period will continue to apply to product certifications, since Dodd-Frank only allows CFTC to prevent listing of certain enumerated event contracts (war, terrorism, assassination and gaming).

There will be a 60 day public comment period on this proposal.

Proposed rule was approved as presented via unanimous vote of Commissioners

2) Removal of Reliance on Credit Rating Agencies

Division of Office of General Counsel gave this presentation. Title IX of Dodd-Frank required CFTC (among other agencies) to remove reliance on credit rating agencies. Section 939A 1) Review regulations for references to credit rating agencies, 2) Remove references to credit ratings and 3) report back to Congress. As it relates to CFTC rules, there were 5 rules identified as referencing credit ratings. Generally, those references are replaced with a creditworthiness standard.

There will be a 30 day public comment period on this proposal.

Proposed rule was approved as presented via unanimous vote of Commissioners.

3) Investment of Customer Funds Under Reg. 1.25 and 30.7

Division of Clearing and Intermediary Oversight gave this presentation. CFTC Rule 1.25 lists the types of investments in which customer funds can be invested (i.e., what an FCM or DCO can do with cash collateral that it receives from a from a customer).

The proposal makes recommended changes to permitted investments (by types) and imposes asset based concentration limits (i.e., FCM can invest no more than a stated percentage of its aggregate customer funds into this type of permitted investment), as follows:

Proposed rule will also limit in-house transactions (including repurchase agreements with an affiliate) and recommend a 5% counterparty limit on repurchase agreement. Also, there will be changes recommended to Rule 30,7 to conform the types of permitted investments for foreign FCM funds to the permitted investment types in Rule 1.25.

Proposed rule was approved as presented with one exception: amendment per Chairman Genstler to include specific questions on money market funds (is 10% correct?). Proposal was approved via majority vote of Commissioners (with one dissent).

4) Process of Reviewing Swaps for Mandatory Clearing

Division of Clearing and Intermediary Oversight gave this presentation, which included discussion of the eligibility of an existing DCO or new DCO to clear a swap, the process for submitting swaps for clearing and the ability of the CFTC to mandate clearing, as well as the stay from the clearing requirement. The goal of the CFTC is to have this rule in place by April 15, 2011, so that the 90 day review can be completed by the July 2011 effective date for Dodd-Frank Title VII.

Commissioner Sommers asked a very practical question about how to review a large number of similar interest rate swaps submitted for approval by a clearinghouse. Presenters response suggested that this will be handled on a “learn as we go” basis.

Proposal was approved via unanimous vote of Commissioners.

5) Anti-Manipulation Rules

Division of Enforcement gave this presentation - focus on two aspects of Section 753                        1) Fraud Based Manipulation: Use of manipulative or deceptive device or contrivance in connection with a CFTC regulated transaction (this includes electronic or algorithmic based trading programs) and represents the introduction of a “recklessness” standard. From the CFTC perspective, this is all based upon effect of activity on the market (rather than the SEC’s disclosure based regime); and

2) Price Based Manipulation: Affirmation of CFTC’s prohibition on price manipulation in respect of swaps, futures or commodities, as well as manipulation that arises by false reporting of positions.

Subject to approval and comment periods, rules will be effective 60 days after rules are published or 360 days after Dodd-Frank (whichever is later).

Proposal was approved via unanimous vote of Commissioners.

6) Proposals regarding Disruptive Trading Practices

Division of Enforcement gave this presentation, although almost all of the divisions contributed. This was to consider an Advance Notice of Proposed Rulemaking regarding Section 747 of Dodd-Frank. Under this section, there are a number of disruptive trading practices, including:

                i) Violating bids or offers

                ii) Spoofing (bidding or offering with the intent to cancel the bid or offer before execution);

                iii) Practices that demonstrate intentional or reckless disregard for the orderly execution of transactions during the closing period.

There is also open-ended rulemaking authority given to CFTC to adopt rules to prohibit practices that disrupt fair and equitable trading.

There will be a public roundtable on December 2^nd to discuss the ANOPR.

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 WHAT: CFTC to hold Public Meeting on Third Series of Proposed Rules. Topics  to be discussed:

1) Prohibition of market manipulation and disruptive trading practices

2) Provisions common to registered entities

3) Removing any reference to or reliance on credit ratings in Commission regulations and proposing alternatives

4) Process of review of swaps for mandatory clearing

5) One Non Dodd-Frank proposed rule – Investment of customer funds and funds held in an account for foreign futures and foreign options transactions

BENEFIT OF PARTICIPATING: Market participants will gain insight into preliminary approach to regulatory structure that will be put into place to address central clearing and perceived trading abuses

WHO MAY BE INTERESTED IN PARTICIPATING: Legal, compliance, treasury and risk management functions, as well as institutional client representatives (sales coverage), of

a) Energy and agricultural traders, physical commodity traders, especially with respect to trade disruption proposals
b) Asset managers and their institutional clients
c) Swap dealers and major swap participants
d) Clearinghouses (i.e., DCO's and clearing agencies)
e) Swap execution facilities (SEFs)

Bottom line: If you trade or deal in derivatives (or someday expect to trade or deal in derivatives), then you probably have an interest in the topics that will be covered by this roundtable since it will discuss the shape of central clearing and possible avenues of regulatory inquiry into your trading and/or dealing programs

DATE: October 26th (With Apologies for Late Posting by TSR)

TIME: 9:30 a.m. to 12:30 p.m. EST

HOW TO PARTICIPATE (According to CFTC website):

Watch a live broadcast of the meeting via webcast on www.cftc.gov

OR Dial in at

US Toll-Free: 1-866-844-9416
• Passcode: 28228

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The second half was all about costs - how will increase and who will pay for those increases.

An hour's worth of very good and technical discussion about the of mutualization of losses. Issues discussed were:

Use of initial margin vs. increases to a guarantee fund vs. doing both

Making independent seg optional vs. mandatory (and effect on the ability of a customer to recover in the event of a loss)

Transmission of systemic risk through design of margin and guarantee fund models.

Clearinghouse Views: The more you alter pooling of margin and / or customer positions, then there is an increased likelihood of increased costs through increased guarantee fund and/or increased margin. If the costs are too high, then the number of clearing members may decrease, the cost to remaining CMs may increase, and there may be decreased liquidity in clearing. Because of these potentially bad outcomes, clearinghouses reiterated their view that individual seg should not be mandated but rather should be optional.

Buy-side Views: Interesting - all agree that customers will pay more, regardless of whether costs take form of increased margin or guarantee funds. Fiduciary representatives expressed a view that increased costs for customers are expected - likely to manifest itself  as a drag on performance. Interesting point was made by the representative from the agriculatural sector - if margin gets too high, then even bona fide hedgers will simply not use the market.

Miscellaneous Notes

1) Insurance Fund: The insurance fund approach was thrown out again for discussion (purely editorial view of TSR is that it received a chilly reception from one CFTC representative on the basis that there is already enough to do under Title VII and that sort of a structure does not yet exist).

2) Closing View:  Much remains to be done on the issue of individual seg and costs; lots of talk, little in the way of discernible trends to the outcome of today's roundtable (other than everybody can expect margin to increase one way or another).

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This roundtable is now on break and here is the half-time report.

BUYSIDE COMMENTS: Not all clients choose tri-party control agreements, but those who do understand that there are incremental costs and are willing to pay those incremental costs. The re-tooling of the market as a result of movement from bi-lateral to cleared OTC markets should be accomplished in a way that increases the risk to buy-side firms.

FCM & CLEARINGHOUSE COMMENTS: Individual segregation of collateral is not the only protection available to the buyside. Mandating that customers be given individual segregation rights will cost the industry (and, by extension, customers) a good deal of money, since the operational system is not intact to support individual seg accounts.

CFTC COMMENTS: CFTC is charged with protecting the public, not the various panelists interests per se. Congress just adopted a statute whose concern is to mitigate systemic risk - if we do not get this issue right, then the implementation of the Congressional mandates will have the opposite effect.

Existing clearing model is an omnibus system; buyside prefers a fully segregated model. Dodd-Frank that you cannot use one customer's collateral to secure another customer's position; and, you can not commingle customer property with dealer property (although, all swap customer's collateral can be co-mingled). So, the CFTC has a hybrid model that it is considering for swap margin/collateral:

1) Customers post collateral on a gross basis;

2) On a daily basis, every clearing member sends information to clearinghouse regarding every customer's portfolio information;

3) Based on that information, the minimum FCM collateral positions will be established;

4) The FCM will post collateral;

5) In the event of an FCM insolvency, the customer will be entitled to the value of the collateral for its set of positions and each customer will be treated separately.

6) The clearinghouse will have the opportunity to transfer the positions, but the clearinghouse must have the unfettered right to liquidate positions if that is in their best interests.

Described by buy side panelist as "legally segregated, operationally omnibus" model - good description. 

Miscellaneous Discussion Points

1) INSURANCE FUND? There was an interesting idea presented of establishment of an insurance pool to protect the loss of collateral.

2) NEED FOR IMPROVED TRANSPARENCY And this was interesting - there needs to be improved transparency for the market to function properly - the clearinghouse needs to be able to see market risk of positions through the FCM and the customer positions with clarity, so that risk can be properly managed.

The second half will be all about costs - how much, how much, how much - from whom, from whom, from whom.

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Answer: Some of you may be wondering if your bank will be regulated in the U.S. as a swap dealer. The Dodd-Frank Act says that if an entity’s swap activities have “a direct and significant connection with the activities in, or effect on, commerce in the United States,” then the CFTC has jurisdiction. The statute also gives the Commission broad authority to “prevent the evasion of any provision” of the Dodd-Frank Act. So in essence, if your bank is doing business here in the U.S., offering swaps to U.S. counterparties, you may want to take a close look at the statute.

CFTC Commissioner Gary Gensler
October 21st
Remarks Before the Institute of International Bankers

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THE FIRST SIX PARAGRAPHS USE "STORYTELLING" AS A WAY TO EDUCATE - IF YOU DO NOT ENJOY STORYTELLING, THEN SKIP DOWN TO "WOULD YOU PLEASE STOP THIS STORYTELLING NON-SENSE TSR?!?!" AND READ FROM THERE TO THE END

A long time ago in a galaxy far, far away, certain derivative trade counterparties called mutual funds (registered investment companies to enlightened 1940 Act bar) could not post collateral directly with a swap dealer due to regulatory restrictions - in particular, the collateral is an asset of the fund that had to be kept in the custody of the bank that the fund's board had tasked with the safekeeping of the fund's assets (see Section 17 of the Investment Company Act of 1940).

So, to address these regulatory restrictions these so-called "mutual funds" entered into an agreement - that was ancillary to their ISDA Master Agreement - with the derivative trade counterparty and the fund custodian that:

1) Required the fund custodian (the "Intermediary") to hold collateral posted by the fund (as the "Pledgor") for the benefit of the trade counterparty (as the "Secured Party") in a separate account ; and

2) Allowed the Secured Party to exercise exclusive control over the collateral if the Pledgor defaulted under the terms of the related ISDA Master Agreement.

Because there were three parties (Pledgor, Secured Party, Intermediary) to the agreement and the subject matter was who had control over collateral, the agreements came to be known as "Tri-Party Account Control Agreements" (how unoriginally descriptive in a legal kind of way!).

Initially, many Secured Parties resisted this idea, but slowly after the turn of the last millennium (assuming that we all agree for purposes of this tale that was 2000), it became accepted that the 1940 Act bar was not fabricating the Section 17 issue. Also,  in the meantime, a number of pension plans grew fond of the concept and starting telling their fiduciaries - don't post collateral directly with a swap dealer, rather keep them with our custodian. It can not be verified, but it is rumored that counsel to some of these fiduciaries really enjoyed saying, "Their clients made them do it."

Then, becoming more facile with these agreements, several (but certainly not all) Pledgors began to demand that they be allowed to exercise exclusive control over the collateral prior to any default occurring. But the Secured Parties countered that the starting point for control should be the ISDA collateral document (which does not give the Pledgor exclusive control at any point in time),  so many (but not all Pledgors) settled on joint control prior to the occurrence of an event of default.

Then, in the year 2008, a certain investment bank named Lehman went bankrupt, causing a lot of market participants to sit up an ask "WHAT DO ALL OF THOSE DERIVATIVE TRADING AGREEMENTS MEAN AGAIN?" And, after that experience, some (but certainly not all) Pledgors started to demand that they have exclusive control over collateral to which the Secured Party was not otherwise entitled if a) the Secured Party was in default and b) was not responsive to the very reasonable demands of the Pledgor.

Subsequently, in the year 2010, an act was passed by the U.S. Congress called "The Dodd-Frank Act" or some such thing and, somewhere in the center of that gigantic mass, a provision was inserted into Title VII that said, "A swap dealer's customer can demand that collateral in respect of a non-cleared swap be maintained at an independent-third party custodian" (see Section 724(c), Segregation Requirements for Uncleared Swaps).

And investment management and derivatives lawyers sat up and said, "Here we go again."

WOULD YOU PLEASE STOP THIS STORYTELLING NON-SENSE TSR?!?!

Sure, for the time being. But, as with all storytelling, there is a point larger than the story and here it is.

1) Section 724(c) of Title VII, Dodd-Frank Act allows customers of a swap dealer to demand that their collateral in respect of a non-cleared swap be held by an independent third party custodian.

2) To allow the customer to exercise this right, it may be the case that parties will need to enter into a tri-party agreement among the custodian, the customer (as pledgor) and the swap dealer (as secured party). Essentially, this agreement allows the customer (pledgor) to post collateral through an account at its custodian. The custodian acts as an intermediary between the pledgor and the secured party, holding the collateral for the benefit of the secured party.  Among other things, the tri-party agreement specifies the circumstances under which the secured party and pledgor can exercise exclusive and/or joint control over the collateral. For this reason, the agreement is often called a tri-party control agreement or a tri-party account control agreement.  It should be noted that it may also be the case that no such "customer level agreement may be required" - the area is one that is subject to possible CFTC rulemaking.  But, the occassion and introduction of section 724(c) does present a good opportunity to focus on the tri-party agreements.

3) Mutual funds and retirement plans have been using these tri-party agreements for quite some time in connection with their OTC derivatives trading activity. In the case of a mutual fund, the use of a tri-party arrangement is a statutory requirement, since Section 17 of the Investment Company Act of 1940 requires, in pertinent part, that the fund's assets be maintained at a bank or, in certain circumstances, a national securities exchange - an exception is made for initial margin on futures contracts under a rule promulgated by the SEC (Rule 17f-6). As an aside, the American Benefits Council submitted a comment letter to the SEC that makes a compelling case for continuing this practice for retirement plans even vis a vis cleared swaps (see page 13 of 16 in the ABC's letter).