On April 18th, 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