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)…
|Regulated Activity and/or Characteristics of a Dealer||Indicia of Regulated Activity or Characteristics||How Does This Relate to Our Business?|
Functional Characteristics Common to Swap Dealers and SBS Dealers
1) Accommodate demand for swaps and SBS
2) Be available to enter into swaps or SBS to facilitate other parties’ interest in entering into swaps or SBS
3) Enter into swaps and SBS on dealer’s standard terms or on terms arranged in response to the other parties’ interest (rather than requesting that the other party propose the terms of the trade)
4) Be able to arrange customized terms for the trade upon request, or to create new types of swaps or SBS at dealer’s own initiative
|Functional Characteristics Unique to a Swap Dealer||
1) Swap dealers enter into swaps with more counterparties than non-dealers; non-dealers tend to enter into swaps with swap dealers more often than with other non-dealers
2) The statutory definition of a swap dealer includes any person that "regularly enters into swaps with counterparties as an ordinary course of business for its own account." In this regard, the December 7th release specifically states, "We believe that persons who enter into swaps as a part of a "regular business" are those persons whose function is to accommodate demand for swaps from other parties and enter into swaps in response to interest expressed by other parties. Conversely, persons who do not fulfill this function should not be deemed to enter into swaps as part of a "regular business" and are not likely to be swap dealers."
|Functional Characteristics Unique to a SBS Dealer||
Generally, the dealer-trader distinction under the Exchange Act will apply to the SBS dealer analysis, as follows:
…[D]ealers normally have a regular clientele, hold themselves out as buying or selling securities at a regular place of business, have a regular turnover of inventory (or participate in the sale or distribution of new issues, such as by acting as a underwriter), and generally provide liquidity services in transactions with investors (or , in the case of dealers who are market makers, for other professionals. (Quoting Securities Exchange Act Release No. 47364 (Feb. 13, 2003))
Of course, the application of this distinction to SBS must take into account distinguishing characteristics of SBS relative to securities (e.g., inapplicability of the concept of "inventory" and "regular place of business").
Significantly, the Regulators expressed a view that, under the dealer-trader distinction, an entity would not be a SBS dealer solely because it uses SBS to hedge business risks.
|Holding oneself out as, and being commonly known in the trade as, a swap dealer or SBS dealer||
By engaging in any one or more of the following:
1) Contacting potential counterparties to solicit interest swaps or SBS
2) Developing new types of swaps or SBS (including financial products with embedded swaps or SBS) and informing potential counterparties that the instruments are available for their trading
3) Being a member in a swap association (e.g., ISDA, SDMA, etc.) in a category reserved for dealers
4) Providing marketing materials (i.e., a website) that describe the types of swaps or SBS that you are willing to enter into with other parties
5) Generally expressing a willingness to offer/provide a range of financial products inclusive of swaps and SBS
6) Dealing in another type of security and entering into a SBS with a cash-market securities customer
7) Expressing your availability to provide liquidity to counterparties that seek to enter into SBS, regardless of direction that you take on the trade or spectrum of risks covered by the trade.
The Regulators further indicated that the determination of whether or not a party is "commonly known in the trade as a dealer or SBS dealer" should be viewed through the lens of market participants with substantial experience in the derivatives markets, rather than the proverbial "man on the street" (who may lack any knowledge of such markets).
|Making a market in swaps or SBS||The Regulators indicated that key indicia of market making in the equities markets – providing a continuous two-sided market and expressing a willingness to buy or to sell – do not necessarily apply to market-making in the swaps and SBS markets – which in some cases are characterized by periods of non-continuous activity. As a result, even non-continuous dealing activities in respect of swaps and SBS may be regulated.|
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