Approaching Ambiguities in the Financial Entity Definition

The third installment of our ongoing series on the 2014 CFTC Reauthorization Act covers a potential change to the definition of a "financial entity", which has been a particularly troublesome and confusing definition for end-users, and the banks that enter into swaps with them. In addition, the CFTC may be able to address the confusion through its rule making and interpretations, without the need for a legislative change.

We will start with an overview of the financial entity definition and some background as to its ambiguities. Those familiar with these issues can read ahead and skip to the potential solutions after the jump 

The Ambiguities Within the Financial Entity Definition

A key part of the End-User Exception to the Dodd-Frank Act clearing and trading requirements is that it is not available to a "financial entity" as defined in Section 2(h)(7)(C) of the Commodity Exchange Act. (For more on the End-User Exception, see our prior post, including a walking map to claiming the End-User Exception). Section 2(h)(7)(C) includes all of the following as financial entities:

  • swap dealers and security-based swap dealers;
  • major swap participants and major security-based swap participants;
  • commodity pools;
  • private funds (as defined in Section 202(a) of the Investment Advisers Act of 1940); and
  • employee benefit plans (as defined in paragraphs (3) and (32) of the Employee Retirement Income Security Act of 1974).  

Those descriptions are defined and clear. The Dodd-Frank Act, however, also added a catch-all prong in the financial entity definition which includes: "a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section [4(k) of the Bank Holding Company Act ("BHCA")]" (the “Catch-All”).

Congress' intent in the Catch-All was to avoid having a loophole allowing entities to avoid the clearing and trading requirement. However, the Catch-All adds multiple layers of ambiguity onto the definition of a financial entity and the resulting ability to claim the end-user exception. First, the definition of "predominantly" with respect to the Catch-All is never clearly defined, either in Title VII of the Dodd-Frank Act or the CFTC rules. We note that Titles I and II of the Dodd-Frank Act also contain tests using language similar to the Catch-All on the financial entity definition, but in each case, the statute also provides a specific test of what “predominantly engaged” means (i.e., 85% of the consolidated revenues comes from financial activities), but we note that each title has a slightly different test. Title VII of the Dodd-Frank Act provided no such test. In the CFTC’s adopting release for the end-user exception, it described that when financial activities are incidental and not primary activities, the entity is not “predominantly” engaged in financial activities, but CFTC has not provided a clear rule for what constitutes being “predominantly” engaged.

In addition, the use of activities "that are in the business of banking" or "are financial in nature, as defined in section [4(k) of the BHCA]" result in ambiguity and confusion as to the application of the definition.

To understand the confusion, we first have to look at the purpose of the business of banking and Section 4(k) of the BHCA. Banking regulation generally limits the activities of banks and precludes them from engaging in commercial activities (considered to be too risky for a bank). However, over the years, the prudential bank regulators have allowed banks to engage in certain activities that are related or incidental to banking operations or are financial in nature. For example, a bank is permitted to engage in trust services, real estate settlement, and courier services for money or checks. The business of banking and Section 4(k) of the BHCA are permissive regulations that define what activities a bank may engage in. However, the Catch-All refers to those terms to define what activities are financial and those permissive regulations do not cleanly apply to the application of financial entity definition. Moreover, commercial entities (or those entities that people would typically consider commercial) also engage in some of the activities that banks are permitted to engage in. In the adopting release for the end-user exception, the CFTC specifically declined to interpret what activities fall under the business of banking and Section 4(k) of the BHCA because those terms come from statutes interpreted by the Office of the Comptroller of the Currency (the “OCC”) and the Board of Governors of the Federal Reserve (the “Fed”), respectively.

Importantly, Section 4(k) of the BHCA includes engaging as principal in forward contracts, options, futures, swaps, and similar contracts. However, many commercial manufacturers, producers, shippers, energy firms and others use those exact products to hedge and manage their risks and in an incidental or ancillary role to their commercial activities.

In addition, many corporations are structured so that all of the organization’s treasury, borrowing, and hedging activities are located in one subsidiary (a treasury affiliate). A treasury affiliate would likely be a financial entity under the Catch-All, while the same activities ultimately for the same company, under a different organizational structure, would not be a financial entity

For those readers that have stuck with us this long, we continue with some potential solutions after the jump . . .

Potential Solutions for the Financial Entity Definition

Section 351 of the CFTC Reauthorization Act would add an additional limitation to the definition of a financial entity. The limitation would exclude from the definition any entity that:

  • is not described in the financial entity prongs other than the Catch-All;
  • is not supervised by a prudential regulator; and
  • either
    • is a “commercial market participant” that is considered a financial entity due to its involvement in physical delivery contracts; or
    • enters into derivative contracts to hedge or mitigate commercial risks of an affiliate that is not supervised by a prudential regulator.

Section 351 then defines a "commercial market participant” as a producer, processor, merchant or commercial user of a non-financial commodity.

The solution in Section 351 addresses the most pressing issues with the current definition of a financial entity, treasury affiliates and commodity producers and merchants, but it does not address some of the inherent ambiguities in the Catch-All.

Another approach can be seen in the rules requiring swap dealers and major swap participants to hold margin for uncleared swaps (the "Re-Proposed Margin Rules"). See our prior post for more information on the Re-Proposed Margin Rules. The prudential regulators initially proposed to use the financial entity definition to distinguish between commercial and financial swap counterparties. However, in the Re-Proposed Margin Rules, the prudential regulators recognized the difficulty of working with the ambiguities in the Catch-All and stated that: "In order to provide certainty and clarity to counterparties as to whether they would be financial end users for purposes of this proposal, the financial end user definition provides a list of entities that would be financial end users as well as a list of entities excluded from the definition." (79 Fed. Reg. 57348, 57360 (emphasis added)). Recall that the CFTC deferred to the OCC and the Fed with respect to interpreting what activities are in the business of banking or are financial in nature, as defined in Section 4(k) of the BHCA, and here, those same regulators are opting to use an alternate definition to avoid ambiguities in the Catch-All.

With respect to the End-User exception, the CFTC cannot create an entirely new definition because it is bound by the language in the Dodd-Frank Act. However, the CFTC can interpret the ambiguous portions of the financial entity definition. Title VII of the Dodd-Frank Act provided no definition of "predominantly engaged" for the financial entity definition and the prudential regulators have indicated that activities that are financial in nature is ambiguous. The CFTC could reasonably interpret the Catch-All to include an enumerated list of entities and exclude a separate list of types of entities that would not be predominantly engaged in financial activities (ideally this would be the same as the lists in the Re-Proposed Margin Rules).

The CFTC and its staff have been on a recent streak of passing sensible rules, interpretations, and letters addressing problems for end users caused by the Dodd-Frank Act, we hope that the streak continues. The Swap Report

Special thanks to Renold Sossong for his assistance with this post.

Getting Ready for Dodd-Frank: A Checklist for Non-Swap Dealers and Non-Major Swap Participants

Checklist: Non-Swap Dealers / Non-MSPs
Getting Ready For Dodd-Frank


Obtain your LEI / CICI by going to and following applicable instructions

By April 10, 2013                                                   
Report all swaps for which you are the reporting counterparty, as required by Parts 43, 45 and 46 of the CFTC Rules Beginning on April 10, 2013

Maintain all records required by Part 45 of the CFTC Rules

Note: We have assumed that you are already maintaining records required by Part 46 of the CFTC Rules with respect to any "historical swaps".

By April 10, 2013

Adhere to ISDA August 2012 Dodd-Protocol information is available at 

Note: Adherence may require you to put additional written policies and procedures into place, so as to enable you to give certain representations

By May 1, 2013*

*Sooner is better

For a company that is any of the following:

A non-swap dealer bank or other financial entity; or

An investment manager advising affiliated funds or investment accounts 

Put documentation into place to trade swaps that will be subject to central clearing (e.g., specified CDX and iTraxx credit derivatives, as well standard interest rate derivatives that involve USD, EUR, GBP and JPY)

Note: Most likely "suite" of documents will consist of:

a) Futures customer agreement with futures commission merchant (FCM) and OTC Cleared Addendum ; and

c) OTC Cleared Derivatives Execution Agreement (if you intend to execute away from your FCM)

Also, there is an assumption that you are not an "active fund," since your central clearing requirement would have gone into effect in March 2013.

By June 10, 2013



Adhere to ISDA Dodd-Frank Protocol 2.0 by going to 


 By July 1, 2013*

*Sooner is better


For all others , including, but not limited to, the following:

Energy company;

A "corporate" that uses derivatives for hedging and risk management; 

An ERISA pension plan;

An Investment manager advising unaffiliated or "third party" funds and investment accounts

Put documentation into place to trade swaps that will be subject to central clearing (e.g., specified CDX and iTraxx credit derivatives, as well standard interest rate derivatives that involve USD, EUR, GBP and JPY)

Note: Most likely "suite" of documents will consist of:

a) Futures customer agreement with futures commission merchant (FCM) and OTC Cleared Addendum ; and

c) OTC Cleared Derivatives Execution Agreement (if you intend to execute away from your FCM)

 By September 9, 2013

Take all steps required to claim the end-user exception to central clearing, if applicable to you

Note: If you are an SEC reporting company or your stock is publicly traded, then you may need to obtain approvals from your board of directors.

Also, on April 1st, the CFTC issued its final inter-affiliate clearing exception.  The timeline for this rule has not yet been established, as it is contingent upon publication of the final rule in the Federal Register.  However, you may be required to take actions, if you intend to rely upon that rule.  More information can be found at

 By September 9, 2013

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

The End-User Exception to Central Clearing - Available for Free Download

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  

Good day. Good downloading. TSR

The End-User Exception to Central Clearing: A "Walking Map" and Some Introductory Thoughts - NOW IS THE TIME TO FOCUS

 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


Attention Financial Institutions: CFTC Proposes Inter-Affiliate Swap Exemption from Central Clearing Mandate


 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.


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.


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

Op-Ed: Systemic Risk is the New Communism (And The Teamsters See It Everywhere)

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


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.