The Commodity Futures Trading Commission (CFTC) has issued a notice of proposed rulemaking (NPR) proposing changes to the de minimis exception under its definition of “swap dealer” (the De Minimis Exception).1
The CFTC proposed that the threshold applicable for purposes of the De Minimis Exception (the Threshold) be maintained at $8 billion rather than reduced to $3 billion, as required by earlier rulemaking.2 That change would be straightforward, and the market has long expected it.
More significantly, the CFTC proposed changes to the manner in which swap dealing activity is measured for purposes of the De Minimis Exception, including in relation to “hedging” swaps and to swaps related to certain customer loans. Arguably, the proposed changes would effectively alter how swap dealing is defined under rules that the CFTC and the Securities and Exchange Commission (SEC) jointly adopted in 2012 (the Joint Rules).3 Accordingly, the NPR drew a stinging dissent from one Commissioner on procedural grounds. The NPR also sought public comment regarding several related aspects of the De Minimis Exception, suggesting the potential for additional important changes, including how cleared and/or exchange-traded swaps are treated for purposes of the De Minimis Exception.
Comments in response to the NPR must be submitted on or before August 13, 2018.
Swap Dealer Definition and the De Minimis Exception
The Dodd-Frank Wall Street Reform and Consumer Protection Act required that the CFTC and SEC jointly adopt rules related to the definitions of “swap dealer” (for purposes of the CFTC’s swap regulation) and “security-based swap dealer” (for purposes of the SEC’s security-based swap regulation). It also required an exception for entities that engage in de minimis quantities of swap dealing in connection with transactions with or on behalf of customers. Thus, the Threshold, together with other aspects of the De Minimis Exception, was established by the Joint Rule.4
The Joint Rule set the Threshold at $3 billion, subject to a phase-in period during which the Threshold was set at $8 billion. Under the Joint Rule, the Threshold would have dropped to $3 billion at the end of 2017, but the Threshold has been maintained to date at $8 billion through prior CFTC action.5
To apply the Threshold, a swap market participant measures the aggregate gross notional amount (AGNA) of swaps connected with its swap dealing activities (and those of its commonly controlled affiliates) over a prior 12-month period. If the AGNA is less than the Threshold, the swap market participant is deemed not to be a swap dealer pursuant to the De Minimis Exception.
Although the De Minimis Exception, including the Threshold, was established jointly by the two commissions, the statute allows the CFTC to unilaterally modify elements of the De Minimis Exception, including the Threshold. As discussed below, one of the Commissioners voted against issuing the NPR on the basis that the CFTC, in acting unilaterally, had failed to respect “the difference between what is permissible and what is proper.”
Proposed Change to the Threshold
In the NPR, the CFTC proposed that the Threshold be set at $8 billion permanently. The NPR discusses the results of extensive data collection and analysis undertaken by the CFTC’s staff with respect to how, and the extent to which, regulatory coverage of swap dealers would change if the Threshold were reduced to $3 billion (or increased above $8 billion). Based on that data collection and analysis, the CFTC concluded:
The policy objectives underlying [swap dealer] regulation—reducing systemic risk, increasing counterparty protections, and increasing market efficiency, orderliness, and transparency—would not be significantly advanced if the threshold were to decrease to $3 billion or to increase from the current $8 billion level.6
Accordingly, the CFTC proposed to maintain the Threshold at a permanent level of $8 billion.
Other Proposed Changes to the De Minimis Exception
The Joint Rule excluded certain swaps from consideration for purposes of determining whether a swap market participant is a swap dealer. Those exclusions apply not only when a swap market participant considers whether the De Minimis Exception is available; they apply also more generally for purposes of the CFTC’s definition of swap dealer.7 The excluded swaps under the Joint Rule include (i) certain swaps executed by insured depository institutions (IDIs) with customers in connection with customer loans and (ii) certain swaps entered into for hedging purposes. In the NPR, the CFTC criticized the narrowness of those two exclusions under the Joint Rules. However, the CFTC did not propose to modify the Joint Rules’ exclusions, which, of course, would require joint action with the SEC. Instead, it proposed to achieve a similar end by taking narrower action: amending only the De Minimis Exception itself.
The CFTC also proposed taking a similar approach — amendments to the De Minimis Exception — for two additional purposes: (i) to introduce an exclusion for swaps entered into in connection with multilateral swap portfolio compression exercises and (ii) to delegate to the Director of the CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO) authority to determine the methodology by which notional amounts are determined for certain purposes of the De Minimis Exception.
As the CFTC noted in the NPR, the statute allows the CFTC to make the proposed changes to the De Minimis Exception without engaging in further joint rulemaking with the SEC.8 Commissioner Rostin Behnam, who voted against the NPR, agreed that it was “within the Commission’s authority” to revise the De Minimis Exception as proposed. However, he stated that, “in utilizing the de minimis exception to address longstanding concerns with the IDI and physical hedging exclusions, the Commission stopped respecting the difference between what is permissible and what is proper.”9
Swaps Entered Into by IDIs in Connection With Customer Loans
The NPR would expand, for purposes of applying the De Minimis Exception, the Joint Rules’ exclusion for swaps executed by IDIs with customers in connection with originating loans for those customers. That exclusion is subject to various conditions related to (i) the timing, the type and the size of the swaps that are covered and (ii) the nature of qualifying loans.
The CFTC summarized its proposed expansion of the exclusion for purposes of the De Minimis Exception as follows:
The proposed IDI De Minimis Provision includes: (1) A lengthier timing requirement for when the swap must be entered into; (2) an expansion of the types of swaps that are eligible; (3) a reduced syndication percentage requirement; (4) an elimination of the notional amount cap; and (5) a refined explanation of the types of loans that would qualify.10
Swaps Entered Into for Hedging Purposes
The Joint Rule permits a hedging swap to be excluded from consideration in connection with the swap dealer definition if the swap is entered into for purposes of hedging certain physical positions. The text of the Joint Rule does not, however, address other kinds of hedges. In that regard, the CFTC observed:
[T]he absence of an explicit exclusion in the regulations for swaps entered into for purposes of hedging financial positions has caused uncertainty in the marketplace regarding whether swaps that hedge, for example, interest rate risk, credit risk, or foreign exchange risk, would also need to be counted towards a person’s de minimis threshold.11
The NPR proposes to amend the De Minimis Exception by permitting a swap market participant to exclude swaps that hedge a financial or physical position and that meet the following conditions:
- The person is entering into the swap for the primary purpose of reducing or otherwise mitigating one or more specific risks for the person, which includes, without limitation, market risk, price risk, rate risk, basis risk, credit risk, volatility risk, foreign exchange risk, liquidity risk or similar risks arising in connection with existing or anticipated identifiable assets, liabilities, positions, contracts or other holdings of the person or any affiliate of the person.
- For that swap, the person is not the price maker and does not receive or earn a bid/ask spread, fee, commission or other compensation for entering into the swap.
- The swap is economically appropriate to the reduction of risks that may arise in the conduct and management of an enterprise engaged in the type of business in which the person is engaged.
- The swap is entered into in accordance with sound business practices.
- The person does not enter into the swap in connection with activity structured to evade designation as a swap dealer.
The NPR suggests that even if a swap dealer hedges financial risks that arise from its swap dealing activity, the swap dealer may exclude the hedging swaps for purposes of the De Minimis Exception if those swaps do not themselves reflect counterparty-driven dealing activity, as evidenced by the hedging swaps’ meeting the conditions listed above. The key condition is that the swap dealer is a price taker in connection with the swaps:
The requirements that the person not be a price maker of the swap or receive compensation for the swap should ensure that the Hedging De Minimis Provision does not improperly exclude swap dealing activity. . . . When the person is not the price maker of the hedging swap, or otherwise receiving compensation, the person is not accommodating the needs of a counterparty, such swap is generally not swap dealing activity, and therefore [such swap] should not be counted for purposes of the de minimis exception.12
The NPR also indicates that if a hedging swap were not to satisfy the conditions listed above, the swap would not necessarily represent swap dealing activity. Rather, any such hedging swap would then be considered in light of all the other relevant facts and circumstances to determine whether the person is engaging in activity (e.g., market making, accommodating demand) that brings the person within the swap dealer definition.13
Swaps Resulting From Compression Exercises
The NPR would revise the De Minimis Exception to exclude swaps that result from multilateral portfolio compression exercises. That revision would be consistent with a 2012 no-action letter issued by the DSIO.14
Calculating Notional Amounts
The final provision that the CFTC proposes to add to the De Minimis Exception (i) would authorize the CFTC to determine the methodology to be used to calculate the notional amount for any group, category, type or class of swaps for purposes of the De Minimis Exception and (ii) would delegate that authority to the Director of the DSIO.15 Publication of such methodology would be beneficial for products that typically do not include a notional amount, such as commodity transactions.
Additional Comment Sought
Other Means by Which Swap Dealing Activity Is Identified
The NPR solicited comment regarding additional factors that might be taken into account for purposes of determining whether a swap market participant qualifies for the De Minimis Exception. The CFTC indicated that it is reconsidering the merits of relying solely on comparing the Threshold to the aggregate gross notional amount—or AGNA — of a person’s dealing swaps. The CFTC therefore sought comment regarding a “dealing counterparty count” threshold and a “dealing transaction count” threshold. Those two kinds of thresholds, together with the AGNA-based Threshold, would work in combination such that a swap market participant would qualify for the De Minimis Exception if its swap dealing activity were below any of the three thresholds.
Although the CFTC did not propose a specific rule change with respect to the additional factors,16 it did offer specific thresholds in respect of which it was seeking comment:
Based on this preliminary analysis, the Commission is seeking comment on whether it would be appropriate to establish a dealing counterparty count threshold of 10 counterparties and a dealing transaction count threshold of 500 transactions.17
Exchange-Traded and Cleared Swaps
The Joint Rule excludes certain exchange-traded and cleared swaps from consideration in connection with the swap dealer definition, but only if they are entered into by registered floor traders, among other conditions. In the NPR, the CFTC sought comment regarding expanding the exclusion for purposes of the De Minimis Exception:
The Commission is seeking comment on whether an exception from the de minimis calculation for swaps that are executed on an exchange (e.g., a swap execution facility (“SEF”) or designated contract market (“DCM”)) and/or cleared by a DCO is appropriate, and may take into consideration comments received regarding possible exceptions based on these factors in formulating the final rule.18
The CFTC indicated that in evaluating comments, it would take into account both systemic risk considerations and counterparty protection policy considerations.
Treatment of Non-Deliverable Forwards
A non-deliverable forward (NDF) is a foreign exchange forward transaction that is cash-settled based on changes in exchange rates for the two currencies during the term of the transaction. However, unlike deliverable foreign exchange forwards (which benefit from a general exemption from the definition of “swap” for most purposes under the Commodity Exchange Act), NDFs are treated as swaps for purposes of the CFTC’s swap rules, including the De Minimis Exception. In the NPR, the CFTC observed that “markets continue to treat both NDFs and deliverable foreign exchange forwards as the same functional product.”19 Accordingly, the CFTC sought comment regarding whether a swap market participant should be permitted to exclude NDFs from consideration when calculating the AGNA of its swap dealing activity for purposes of the De Minimis Exception.
1 The NPR was published in the Federal Register on June 12, 2018, and is available here.
2 The NPR does not propose changes to the de minimis exception applicable to “special entities”; it would remain $25 million.
3 CFTC and SEC, Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant;” Final Rules, 77 Fed. Reg. 30596 (May 23, 2012), available here. See Sidley Update, CFTC and SEC Finalize Key Dodd-Frank “Entity Definitions” (May 11, 2012).
4 The Joint Rule also established an analogous threshold for SEC security-based swap dealer registration (and other aspects of the SEC’s de minimis exception for security-based swap dealers).
5 See NPR at 27445 note 15 and accompanying text (describing two related CFTC orders).
6 NPR at 27450.
7 Before seeking to rely on the De Minimis Exception, a swap market participant would generally have concluded that it is, or may be, a swap dealer as defined in the CFTC’s rules: “any person who: (i) [h]olds itself out as a dealer in swaps; (ii) [m]akes a market in swaps; (iii) [r]egularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) [e]ngages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.”
8 The CFTC explained that “[a] joint rulemaking is not required with respect to changes to the de minimis exception-related factors.” NPR at 27458 note 120; see also Commodity Exchange Act Section 1a(49)(D) (“The [CFTC] shall promulgate regulations to establish factors with respect to the making of [the de minimis] determination to exempt”).
9 NPR Appendix 4, at 27481-82 (“Dissenting Statement of Commissioner Rostin Behnam”).
10 NPR at 27459.
11 NPR at 27462.
12 NPR at 27463.
13 NPR at 27463.
14 CFTC Staff Letter No. 12–62, No-Action Relief: Request that Certain Swaps Not Be Considered in Calculating Aggregate Gross Notional Amount for Purposes of the Swap Dealer De Minimis Exception for Persons Engaging in Multilateral Portfolio Compression Activities (Dec. 21, 2012), available here.
15 The DSIO has issued interpretative responses to certain questions regarding calculating notional amounts for purposes of the De Minimis Exception. See DSIO, Frequently Asked Questions (FAQ) — Division of Swap Dealer and Intermediary Oversight (“DSIO”) Responds to FAQs About Swap Entities, available here.
16 The CFTC stated that it may take into consideration comments received regarding any of these factors in formulating the final rule or may in the future consider proposing an amendment to the swap dealer definition to reflect any of these factors for purposes of the de minimis threshold calculation. See NPR at 27466.
17 NPR at 27467.
18 NPR at 27468.
19 NPR at 27470.
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