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