CFTC and SEC Finalize a Key Piece of the Dodd-Frank Act ... · Act Registration Requirements Puzzle with the Final Entity Definitions Rules, but Many Pieces of the Puzzle Remain Missing

Entity Definitions Rule May 8, 2012 1

May 8, 2012

CFTC and SEC Finalize a Key Piece of the Dodd-Frank Act Registration Requirements Puzzle with the Final Entity Definitions Rules, but Many Pieces of the Puzzle Remain Missing

Key Takeaways:

> Swap Dealer and Security-based Swap Dealer determinations parallel

statutory text, but in both cases the scope of the de minimis exemption has

been dramatically expanded, and other useful exclusions, limitations and

interpretative guidance have been provided.

> Major Swap Participant and Major Security-based Swap Participant

determinations also mirror the analysis set forth in Title VII, and the final

rules set out the thresholds that must be met in order to fall within that

statutory definition.

> Eligible Contract Participant definition has been amended and clarified,

particularly with respect to the look through and retail FX provisions.

Introduction

On April 18, 2012, in one of the most anticipated final rulemakings under the

Dodd-Frank Act (“Dodd-Frank Act”)1 to date, the Commodity Futures Trading

Commission (“CFTC”) and the Securities Exchange Commission (“SEC”)

approved for publication in the Federal Register a joint final rule (the “Final

Rule”) with respect to the “Further definition of ‘swap dealer,’ ‘security-based

swap dealer,’ ‘major swap participant,’ ‘major security-based swap participant’

and ‘eligible contract participant.’”2 The CFTC and SEC also adopted a joint

interim final rule (the “Interim Final Rule”) excluding certain hedging swaps from

swap dealing activity such that they would not be included in determining whether

a person is a swap dealer. Since the Dodd-Frank Act was enacted nearly two

years ago, one of our most commonly received questions has been: will we have

to register as a swap dealer (“SD”), security-based swap dealer (“SBSD”), major

1 H.R. 4173 111th Congress (2010).

2 The Final Rule has not yet been published in the Federal Register and all page references herein

are to the pre-publication PDF version available at http://www.cftc.gov/3E72032F-B8FA-46FD-8111-5DC4CD4EA3E5/FinalDownload/DownloadId-69529E5FC71CCAD0B9B0A2D732FD254A/3E72032F-B8FA-46FD-8111-5DC4CD4EA3E5/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf (the “Final Rule Release”).

Contents Introduction ....................... 1

Who is required to register as a “swap dealer”? .......... 3

Who is required to register as a “security-based swap dealer”? ........................... 15

Who is required to register as a “major swap participant”? .................... 16

Who is required to register a “major security-based swap participant”?........... 22

Modifications of and interpretative guidance in respect of the Eligible Contract Participant definition. ........................ 22

Extraterritoriality .............. 26

Effective Dates ................ 26

http://www.cftc.gov/3E72032F-B8FA-46FD-8111-5DC4CD4EA3E5/FinalDownload/DownloadId-69529E5FC71CCAD0B9B0A2D732FD254A/3E72032F-B8FA-46FD-8111-5DC4CD4EA3E5/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf





swap participant (“MSP”) or major security-based swap participant (“MSBSP”)

and, if so, will we have to register in respect of our entire business or only the

relevant portions of our business? These questions are vitally important because

the answers can trigger what many consider to be onerous burdens under the

Dodd-Frank Act.3 When the original CFTC and SEC proposed rulemaking on this

subject matter was published (the “Proposed Rule”),4 the reactions of market

participants varied from stupefaction to outrage and everything in between, as the

Proposed Rule was incredibly broad.5

Much commenting, lobbying and related efforts commenced and the Final Rule

and the Interim Final Rule reflect a significant narrowing of the market

participants that will be caught within the ambit of the registration requirements,

particularly in the case of SDs and MSBSPs.6 The Final Rule also provides

greater guidance on a number of topics than did the Proposed Rule, including the

meaning of various elements of the statutory language. For example, interpretive

guidance has been provided in respect of the various elements of the SD and

SBSD determinations, as well as the overall characterization of those

determinations as being in the nature of a facts and circumstances test rather

than a rigorous application of disjunctive statutory elements in a vacuum.

Notwithstanding the joint nature of the rulemaking in respect of the Final Rule,

there are some differences in approach between the SEC and the CFTC. For

example, the de minimis exemption is set at different levels for the SD and SBSD

determinations.

The Final Rule also makes changes to and provides guidance in respect of the

definition of “eligible contract participant” (“ECP”), which is important because

under the Dodd-Frank Act, only an ECP may enter a swap that is not executed

on a designated contract market or a security-based swap (“SBS”) that is not

executed on a national securities exchange and registered with the SEC and also

because the Dodd-Frank Act effected a number of changes to the definition of

ECP under the Commodity Exchange Act (“CEA”). The definition of ECP has

been expanded to include MSPs, SDs, MSBSPs and SBSDs, but tailored to

3 For example, in addition to registration requirements, compliance with margin, capital and internal

and external business conduct rules. Final Rule Release at 11; see also Melnick, Forbes-Cockell & Renas, CFTC Adopts Final External Business Conduct Rules Transforming Swap Disclosure and Fundamentally Altering the Interaction Between Most Swap Counterparties, Futures & Derivatives L. Rep., Vol. 32 No. 3, March 1, 2012.

4 See CFTC and SEC, Notice of Proposed Joint Rulemaking: Further Definition of “Swap Dealer,”

“Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 75 FR 80174 (Dec. 21, 2010) available at http://cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-31130a.pdf.

5 See, e.g., Letter of Russell Goldsmith, Midsize Bank Coalition of America, dated February 22,

2011, stating in reference to the de minimis exception in the Proposed Rule that “[w]e believe that these criteria are too narrow; most, if not all, small dealers will fail to meet these criteria effectively eliminating the usefulness of the de minimis exemption and disregarding the legislative intent for including such an exemption.”

6 See Open Meeting of the 26th Series of Rulemakings Under Dodd-Frank Act (April 18, 2012), p.61,

comments of Commissioner Bart Chilton regarding the de minimis threshold. The transcript of the Open Meeting is available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission2_041812-trans.pdf.

http://cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-31130a.pdf

http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission2_041812-trans.pdf



exclude certain types of commodity pools and to provide further clarity on the

“look through” and related “retail FX” provisions.

To make this note as useful a tool as possible we begin by walking through in a

simple narrative way the process for determining whether a person is required to

register as an SD, SBSD, MSP or MSBSP, including a consideration of the

relevant interpretative guidance and the various exemptions and exclusions that

apply. We have also included graphical and tabular representations for ease of

understanding where appropriate. We explore in a bit more detail what each

element of the definitions means, as well as the parameters of the limitations,

exclusions and exemptions based upon the guidance the regulators have

provided, including, where applicable, how they differ.7 We then discuss the Final

Rule as it relates to ECPs. Finally, we conclude with a brief discussion on timing

and effectiveness.

Who is required to register as a “swap dealer”?

Flow Chart of Swap Dealer Determination

Excluded items: (i) swaps activities not part of a regular business; (ii) swaps entered into by an

insured depository institution with a customer in connection with originating a loan to that customer;

(iii) swaps between majority-owned affiliates; (iv) swaps entered into by a cooperative with its

members; (v) swaps entered into for hedging physical positions; and (vi) certain swaps entered into

by registered floor traders.

Overview

The Final Rule Release provides a walkthrough of the analytical process that

should be undertaken in the course of determining whether a person falls within

the SD definition. Excluding swaps not required to be included in the SD

determination, a person must determine, on a facts and circumstances basis

applying the interpretive guidance in the Final Rule Release, whether its activities

7 For example, the definition of hedging under the SD test versus the definition of hedging under the

MSP test. Compare Final Rule Release at 600 with Final Rule Release at 587.

Do you hold yourself out as

a dealer in swaps?

Do you make a market in swaps?

Do you regularly enter

into swaps with

counterparties as an ordinary

course of business for

your own account?

Do you engage in any

activity that causes you to be commonly known in the

trade as a dealer or

market maker in swaps?

Did you exclude the excluded items?

• If not, reassess.

• If so, and you still answered yes to any of them, see if you satsify the de minimis exemption.

If you answered "yes" to any of the questions in the first four boxes above, are your swap dealing activities (i.e. such activities) de minimis?

• If "yes," i.e. total included swaps notional < $8B during initial phase or < $3B during subsequent phase and always less than $25mm with special entities, DO NOT REGISTER as an SD. n.b. in each case measure across affiliated entities, but exclude interaffiliate swaps.

• If "no," YOU MUST REGISTER as an SD.


fit into any of the four enumerated categories of SD activities.8 If any of its

activities are within those categories of SD activities, it must then determine

whether the de minimis exemption applies so as to take that person outside the

definition of swap dealer (i.e., if after the activities analysis a person appears to

fall within the SD definition, the question becomes whether the relevant activity is

within the de minimis exception).9 Above is a high level flow chart of the swap

dealer determination. We discuss the details in greater depth below.

Statutory Definition of Swap Dealer

Section 721 of the Dodd-Frank Act defines a swap dealer as any person:

> holding itself out as a dealer in swaps;

> making a market in swaps;

> entering into swaps with counterparties in the ordinary course of business

for its own account; or

> engaging in any activity causing the person to become commonly known in

the trade as a dealer or market maker in swaps.

Subject to various exclusions and limitations, a person engaged in any one of

these categories of activities may be required to register as an SD even if it is not

engaged in any of the other categories of activities.10

The Dodd-Frank Act includes three further qualifications:

> an insured depository institution (“IDI”) shall not be considered to be a

swap dealer to the extent it offers to enter into a swap with a customer in

connection with originating a loan with that customer;

> a person that enters into swaps for such person’s own account, either

individually or in a fiduciary capacity, but not as a part of a regular

business, will not be a swap dealer; and

> the CFTC shall exempt from designation as a swap dealer an entity that

engages in a de minimis quantity of swap dealing in connection with

transactions with or on behalf of its customers.

The statute also provides that a person may be designated by the CFTC as a

swap dealer for a single type or single class or category of swap or activities and

considered not to be a swap dealer for other types, classes, or categories of

swaps or activities. What seems like a relatively simple statutory provision leaves

much subject to debate and disagreement, including with respect to the nature of

its application and the meaning of its elements and scope. Indeed, Section

712(d)(1) of the Dodd-Frank Act provides that the CFTC and the SEC in

consultation with the Federal Reserve Board shall jointly further define, among

8 Final Rule Release at 49.


10 Final Rule Release at 12 and at 49; see also Final Rule Release at 58, n190.


others, the terms SD, SBSD, MSP, MSBSP and ECP, which is the genesis of the

Final Rule.11

Further Definition of Swap Dealer and Interpretive Guidance

Pursuant to the Final Rule Release, Section 1.3 of the CFTC’s rules under the

CEA has been modified to include a new subsection (ggg), which, largely tracking

the text of the Dodd-Frank Act, defines in clause (1) an SD as “any person who:

> Holds itself out as a dealer in swaps;

> Makes a market in swaps;

> Regularly enters into swaps with counterparties as an ordinary course

of business for its own account; or

> Engages in any activity causing it to be commonly known in the trade

as a dealer or market maker in swaps.”12

Consistent with the text of the Dodd-Frank Act, the Final Rule Release provides

interpretive guidance with respect to the meaning of the four main elements of

the SD definition; addresses the exceptions and exemptions called for by the

statutory text; and also addresses various other exemptions and exclusions

promulgated by rule although not required by the text of the Dodd-Frank Act. We

will discuss these in more detail below, but in particular, they include:

> the IDI exemption;

> the own account/not part of a regular business exemption;

> the interaffiliate exemption;

> the floor trader exemption;

> the cooperative exemption;

> the hedging exemption; and

> the de minimis exemption.

The exemptions listed in the first, second and last arrows were not required by

the text of the Dodd-Frank Act. The hedging exemption was adopted as an

interim final rule rather than as part of the Final Rule and thus remains subject to

public comment.

The Final Rule Release also provides guidance around the limited SD

designation contemplated in the statute and allows for a registrant to apply for

such limited designation at the time it seeks to register or subsequent to

11

Dodd-Frank Act Section 712(d)(1); See also Further Definition of “Swap Dealer,” ‘Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant,” and “Eligible Contract Participant”, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf. Various other provisions of the Dodd-Frank Act also require further definitional rulemaking.


http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf


registration, but the default position is that if you have to register, you must

register the entire enterprise absent such application being granted. As discussed

below, in many cases there may be significant hurdles to such limited designation

registration being permitted.

Interpretative Guidance

The “Dealer-Trader” Distinction

In the Final Rule Release, the Commissions take the view that the “dealer-trader”

distinction that exists in the federal securities laws and related interpretive

guidance “in general provides an appropriate framework for interpreting the

statutory term ‘swap dealer’ . . . [and] forms the basis for a framework that

appropriately distinguishes between persons who should be regulated as swap

dealers and those who should not.”13

The Commissions further noted that the

dealer-trader distinction would need to be adapted to swaps activities in light of

the special characteristics of swaps and the differences between the “dealer”

definition and the “swap dealer” definition.14

The Commissions identify several activities indicative of dealing activity in

connection with the dealer-trader distinction that would also be indicative that a

person is acting as a swap dealer:15

Activities indicative of swap dealing activity

> providing liquidity by accommodating demand for or facilitating interest in

swaps; holding oneself out as willing to enter swaps (independent of whether

another party has already expressed interest), or being known in the industry

as being available to accommodate demand for swaps;

> advising a counterparty how to use swaps to meet hedging goals, or

structuring swaps on behalf of a counterparty;

> having a regular clientele and actively advertising or soliciting clients in

connection with swaps;

> acting in a market maker capacity on an organized exchange or trading

system for swaps (although it is noted that the presence of an organized

exchange is not a prerequisite to market making nor is market making a

13

Final Rule Release at 51. Note, as the Q&A on the Final Rule Release points out, “although the CFTC is not formally adopting the SEC’s dealer-trader precedents, those precedents may be applied to determine if a person is an SD.” http://cftc.gov/ucm/groups/public/@newsroom/documents/file/msp_ecp_qa_final.pdf.

14 Final Rule Release at 51-53. For example, some of the important differences between the swaps and securities markets identified in the Final Rule Release include level of activity; no separate issuer; predominance of OTC and non-standardized instruments; mutuality of obligations and significance to customer relationship. Id. The Commissions go on to say, “As a whole, the relevant statutory provisions suggest that we should interpret the ‘swap dealer’ definition to identify those persons for which regulation is warranted either: (i) due to the nature of their interactions with counterparties; or (ii) to promote market stability and transparency, in light of the role those persons occupy within the swap and security-based swap markets.” Id. at 53-54.

15 Final Rule Release at 54-55. Although these activities are indicative of acting as a swap dealer, engaging in one or more of them is not a prerequisite to a person being a swap dealer. Id. at 54, n.182.

http://cftc.gov/ucm/groups/public/@newsroom/documents/file/msp_ecp_qa_final.pdf


Activities indicative of swap dealing activity

prerequisite to being an SD); and

> helping to set prices offered in the market, e.g. by acting as a market maker,

rather than taking those prices (although regularly taking market prices does

not preclude being an SD).

The Commissions note several other activities consistent with the dealer-trader

distinction that are not prerequisites to being an SD:

Additional Dealer-Trader Distinction Interpretative Guidance

> willingness to enter swaps on either side of the market is not a prerequisite to

SD status;16

> SD analysis does not turn on whether a person’s swap dealing activity

constitutes the person’s sole or predominant business;

> a customer relationship is not a prerequisite to SD status;

> in general, entering into a swap for hedging purposes, absent other activity, is

unlikely to be indicative of dealing; and

> whether a person is acting as a dealer will turn upon the relevant facts and

circumstances, as informed by the interpretative guidance set forth in the

Final Rule Release.

Despite the similarities between the dealer-trading distinction and the

interpretative approach to swap dealing activity, market participants are warned

not to apply the dealer-trader distinction rigidly to the swaps context or to expect

that the analogous CFTC framework will evolve in a manner identical to the way

the dealer-trader distinction has evolved. Indeed, the Commissions expect the

dealer-trader distinction to evolve over time with respect to swaps independently

of its evolution over time with respect to securities or security-based swaps.17

This discussion and the parallel discussion in respect of SBSDs forms the

backdrop for the other interpretive discussion in the Final Rule Release with

respect to the SD and SBSD determinations.

16

Indeed, it is possible for a person making a one-way market in swaps to be a market maker. Final Rule Release at 60-61 (“This may be true, for example, where a person routinely stands ready to enter into swaps on a particular side of the market—say, routinely bidding for floating exposures on a swap trading platform—while entering into transactions on the other side of the market in other instruments (such as futures contracts).”).



The First and Second Main Categories of Swap Dealer Activity: Holding

Itself Out as a Dealer in Swaps or Engaging in Activity Causing Itself to

be Commonly Known in the Trade as a Dealer or Market Maker in Swaps

The prongs of the SD definition that capture a person that “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” provide color to the CFTC’s view

that the SD definition should be applied to the facts and circumstances of a

particular person’s activities. The factors to be considered under both prongs

were originally outlined in the Proposed Rule and are set forth below.18

Holding itself out as a swap dealer or engaging in activity causing it to be

commonly known in the trade as a dealer or market maker in swaps

> contacting potential counterparties to solicit interest;

> developing new types of swaps and informing potential counterparties of their

availability and of the person’s willingness to enter into the swap;

> membership in a swap association in a category reserved for dealers;

> providing marketing materials describing the type of swaps the party is willing

to enter into; and

> generally expressing a willingness to offer or provide a range of products or

services that include swaps.

These indicia “should not be considered in a vacuum, but instead should be

considered in the context of all the activities of the swap participant.”19

Satisfying

any one of them does not conclusively establish SD status and could be

countered by other factors indicating the person is not an SD.20

The Third Main Category of Swap Dealer Activity: Market Making

The essential element of “market making” is “routinely standing ready to enter

into swaps at the request or demand of a counterparty.”21

“Routinely” means

more frequently than occasionally, but does not require that the person do so

continuously.22

Activities indicative of standing ready to enter into swaps at the request or

demand of a counterparty, and thus market making, include routinely:23

Market Making

> quoting bid or offer prices, rates or other financial terms for swaps on an

18

Final Rule Release at 56, note 187. 19

Final Rule Release at 58. 20

Id. 21



Final Rule Release at 59.


Market Making

exchange;

> 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;

> placing limit orders for swaps; or

> receiving compensation for acting in a market maker capacity on an

organized exchange or trading system for swaps.

This is a non-exhaustive list and other activities may constitute market making if

the person engaging in them routinely stands ready to enter into swaps as

principal at the request or demand of a counterparty. The dealer-trader distinction

can also be usefully applied to these four factors because under the dealer-trader

distinction, seeking to profit by providing liquidity to the market is an indication of

dealer activity.24

Thus, in applying these four factors, if the person is seeking,

through its presence in the market, compensation for providing liquidity,

compensation through spreads or fees, or other compensation not attributable to

changes in the value of the swaps it enters into it is likely to be an SD, and if not,

then likely it is not.

The Fourth Main Category of Swap Dealer Activity: Entering Into Swaps

with Counterparties for its Own Account as Part of a Regular Business

and the Exclusion for Swaps Entered Into Other Than as Part of a

Regular Business

One of the statutory and rule elements of the SD definition is entering into swaps

with counterparties for its own account as part of a regular business.

Correspondingly, both the statute and the rule expressly preclude from

consideration in the SD determination swaps not entered into as part of a regular

business. Subsection (ggg)(2) of the Final Rule exempts from the SD definition “a

person that enters into swaps for such person’s own account, either individually

or in a fiduciary capacity, but not as part of a regular business.”25

The

Commissions take the view that the terms regular business and ordinary course

of business are synonymous for these purposes.26

The analysis of whether swaps activity constitutes a “regular business” or is in the

“ordinary course of business” focuses on whether the activity is both “usual and

normal” in a person’s course of business and “identifiable as a swap dealing

24



Final Rule Release at 63. They also note that the “regular business” exclusion is not limited solely to the ordinary course of business prong of the SD definition and that the interpretative guidance on the other three prongs should be read consistently so as to exclude swaps that are not part of a regular business. Id. at n.203.


business”.27

It is not necessarily relevant whether those activities are a person’s

primary or ancillary business so long as they are identifiable as a swap dealing

business.28

Any of the following activities would constitute having a “regular business” of

entering into swaps:29

Entering into swaps as part of a “regular business”

> entering 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);

> maintaining a separate profit and loss statement reflecting the results of swap

activity or treating swap activity as a separate profit center; or

> having staff and resources allocated to dealer-type activities with

counterparties, including activities relating to credit analysis, customer

onboarding, document negotiation, confirmation generation, requests for

novations and amendments, exposure monitoring and collateral calls,

covenant monitoring, and reconciliation.

The Commissions suggest that the “staff and resources” prong of their guidance

on what constitutes a “regular business” is not designed to capture end-users that

may have staff allocated to the activities enumerated under that prong, but rather

is to be applied “in a reasonable manner, to all appropriate circumstances,” and is

targeted at firms that allocate staff and resources to those activities to a

“significant extent”.30

Hedging Swaps and Interaffiliate Swaps Excluded

Pursuant to the Interim Final Rule, in determining whether a person is an SD

certain hedging swaps and interaffiliate swaps are not to be taken into account.

Hedging Swaps

Swaps entered into for the purpose of hedging physical positions can be ignored

in determining whether a person is an SD provided that they satisfy a conjunctive

multi-part test that essentially asks whether:

> the person is entering into the swap for the purpose of offsetting price risks

associated with assets, liabilities or services to which the person has or will

have real exposure,

> the swap is a substitute for transactions made or to be made or positions

taken or to be taken by the person in a physical marketing channel, 27


Id. 29




> the swap is economically appropriate to the reduction of the person’s risk

in the conduct and management of a commercial enterprise,

> the swap is entered into in accordance with sound commercial practices,

and

> the person does not enter into the swap in connection with activity

structured to evade designation as an SD.31

Interaffiliate Swaps

In making an SD determination market participants may also disregard swaps

with majority-owned affiliates. Counterparties are affiliates under the Final Rule if

one counterparty directly or indirectly owns a “majority interest” in the other or if a

third party directly or indirectly owns a majority interest in both.32

“Majority

interest” means the right to vote or direct the vote of a majority of a class of voting

securities of an entity, the power to sell or direct the sale of a majority of a class

of voting securities of an entity, or the right to receive upon dissolution or the

contribution of a majority of the capital of a partnership.33

Although not required

by the text of the Dodd-Frank Act the treatment of interaffiliate swaps was of

concern to many market participants and commentators who argued that they

were fundamentally different in nature than outward facing swaps with the

market.

Floor Trader Exception

In order to avoid the duplicative regulation of persons registered with the CFTC

as Floor Traders that would result were they required to register as SDs, under

the Final Rule parties may ignore swaps entered into by a person in their capacity

as Floor Traders when making an SD determination.34

Cooperative Exception

Swaps entered into by a cooperative with a member of the cooperative can be

disregarded when determining whether the cooperative is an SD, subject to risk

monitoring and management, and reporting requirements, and if the cooperative

is a cooperative association of producers, the swap is primarily based on a

commodity that is not an excluded commodity.35

Insured Depository Institution Swaps in Connection with Originating

Loans to Customers

Swaps entered into by an insured depository institution (“IDI”) with a customer in

connection with originating a loan with that customer shall not be considered in

determining whether the IDI is an SD. To ensure that the Final Rule complies with

the statutory mandate that the swap in question be in connection with the

31







origination of a loan to a customer by an IDI, the CFTC requires the following

elements to be satisfied for the IDI exemption to be utilized:

> the person is an IDI;

> the IDI enters into a swap with a borrower that does not extend beyond the

termination of the loan;

> the swap is connected to the financial terms of the loan or is required by

loan underwriting criteria to be in place as a condition of the loan in order

to hedge the borrower’s commodity price risks (other than excluded

commodities) incidental to the borrower’s business;

> the relevant swap is entered into no more than 90 days before or 180 days

after the date of the execution of the loan agreement, or no more than 90

days before or 180 days after the date of any transfer of principal to the

borrower;

> the loan is within the common law meaning of “loan” (i.e., not synthetic or a

sham loan);

> the IDI is directly or indirectly (where IDI is the source of at least 10% of

the entire loan amount) the source of money to the borrower in connection

with the loan;

> the aggregate notional amount of all swaps entered into by the borrower

with all persons in connection with the financial terms of the loan at any

time is not more than the aggregate amount of borrowings under the loan;

and

> the IDI agrees to report the swap to a swap data repository.36

De Minimis Exception

Subsection (ggg)(4) addresses the “de minimis exception” which is initially $8B in

aggregate gross notional amount over the prior 12 month period, but drops to

$3B in aggregate gross notional amount over the prior 12 month period five years

from the date that a swap data repository first receives swap data in accordance

with the relevant CFTC rules, unless the CFTC changes it.37

From inception,

however, there is a much smaller ceiling on swaps with special entities under the

de minimis exception and that is $25mm in aggregate gross notional amount over

the prior 12 month period. In each case, measuring across all affiliated entities,

but exclude interaffiliate swaps.38

Additionally, with respect to the initial

measurement period, the Final Rule Release provides that the relevant period will

be the period following the effective date of the final products rules if that period

36

Final Rule Release at 112-113. 37




is less than 12 months, but it is not entirely clear what period is being referred

to.39

Even at the fallback level of $3B the Final Rule reflects a significantly more

generous de minimis exemption than the $100mm contemplated in the Proposed

Rule.40

It is also important to note, as the Final Rule Release makes express,

that these references to notional amounts are intended to refer to “effective

notional amount[(s)]” such that if the stated notional is a dollar amount and there

is a multiplier increasing the effective amount of the notional, the effective amount

rather than the stated amount would be used.41

If a person not registered as an

SD by virtue of the de minimis exception can no longer rely on it, such person

shall not be an SD until the earlier of the date it submits an SD application or two

months after the end of the month it can no longer use the exception.42

The Final Rule requires a report to be produced by the CFTC staff no later than

30 months after the date that a swap data repository first receives data in

accordance with the rules on swap data recordkeeping and reporting

requirements.43

The study is essentially intended to assist the CFTC in evaluating

whether the de minimis threshold should be altered and the implications of doing

so. The rationale for this approach is that the SD definition starts out being

narrow by virtue of the higher de minimis threshold and if no action is taken the

definition grows more expansive as a result of the lowering of the threshold.44

However, the study should provide the CFTC with sufficient information to

determine whether an adjustment is required.45

Limited Designation46

The Commissions construe the language in the Dodd-Frank Act providing that a

person may be designated as a dealer for one type, class or category of swap or

security-based swap, or specified swap or security-based swap activities, without

the person being considered a dealer for other types, classes, categories or

activities as “permissive grants of authority that do not require the Commissions

to provide limited designations.”47

Consistent with the Proposed Rule, the Final

Rule also provides for such limited designation, but only upon such person

seeking and receiving a designation as a dealer for only specified categories of

39


See comments of Gary Gensler, CFTC Chairman, Open Meeting Transcript at 8 (“For those who question the level of di minimis, we considered the de minimis threshold in the context of an overall $300 trillion notional swaps market”).


42 Final Rule Release at 568. The corresponding provisions for SBSDs and the de minimis exception to that definition are identical.


44 See comments of Mark Fajfar, CFTC Assistant General Counsel, at the Open Meeting on the 26

th

Series of Rulemakings under Dodd-Frank Act, at 61, a transcript of which is available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission2_041812-trans.pdf (“Open Meeting Transcript”).

45 See comments of Gary Gensler, CFTC Chairman, Open Meeting Transcript at 85, regarding the use of swap data collected by swap data repositories in the preparation of the CFTC staff report.

46 This discussion is identical for SDs and SBSDs so rather than include it twice we have simply referred to both.

47 Final Rule Release at 185 (quoting Proposed Rule).




swap or security-based swap activities.48

The Final Rule clarifies that such an

application may be made at the time a party registers or subsequent to

registration.49

Absent such a limited designation, the presumption remains that a

person who meets one of the dealer definitions will be deemed to be a dealer

with regard to all of its swaps or security-based swaps activities.

Perhaps, most interestingly, the Commissions do not fully deal with the fact that

the statute and the rules are not really set up, in many cases, to deal with an

entity that is an SD or MSBSP for some of its activities, but not others although

they do note that certain requirements were intended to apply at the entity level

(e.g., registration, capital, risk management, supervision and appointment of chief

compliance officers) while others apply at the transactional level (e.g.,

requirements relating to trading records, documentation and confirmations).50

The Commissions skirt around this issue by indicating that anyone applying for

such limited designation will be required to demonstrate that it will be able to

comply with all applicable requirements, “Regardless of the type of limited

designation being requested, the Commissions will not designate a person as a

limited purpose dealer unless it can demonstrate that it can fully comply with the

requirements applicable to all dealers.”51

The Commissions emphasize the same

point several pages later, “A key challenge that any applicant to a limited dealer

designation will face is the need to demonstrate full compliance with the

requirements that apply to the type, class or category of swap or security-based

swap, or the activities involving swaps or security-based swaps, that fall within

the swap dealer designation.”52

It is not entirely clear, as a practical matter, how

this may be achieved. It is likewise unclear how rigorous the Commissions will

be in applying this requirement to such limited designation dealers.

48







Who is required to register as a “security-based swap dealer”?

Flow Chart of SBSD Determination

Excluded items: (i) SBS activities not part of a regular business; and (ii) SBS between majority-owned

affiliates.

Overview

The four-part SBSD definition is substantially the same as the SD definition, with

a similar exception carved out for persons that enter into SBS for their own

account, either individually or in a fiduciary capacity, but not as part of a regular

business.53

Not surprisingly, the dealer-trader distinction is also relevant to the

interpretation of the SBSD definition.54

A key distinction between the SD and SBSD regimes is the de minimis exception.

For SBS dealing activity involving credit default swaps that are SBSs, there is an

aggregate gross notional phase-in threshold of $8B, which may be lowered to

$3B automatically upon termination of the phase-in period or varied pursuant

further rulemaking. With regard to SBSs that are not credit default swap that are

SBSs, there is a phase-in threshold of $400mm in aggregate gross notional

value, which fades to $150mm upon termination of the phase-in period or which

may be varied by further rulemakings.

53



Do you hold yourself out as

a dealer in SBS?

Do you make a market in

SBS?

Do you regularly enter into SBS with counterparties as an ordinary

course of business for

your own account?

Do you engage in any

activity that causes you to be commonly known in the

trade as a dealer or

market maker in SBS?

Did you exclude the excluded items?

• If not, reassess.

• If so, and you still answered yes to any of them, see if you satsify the de minimis exemption.

Are your SBS dealing activities de minimis?

• If yes, i.e. total included CDS that are SBS aggregate notional < $8B during initial phase or < $3B during subsequent phase; non-CDS SBS aggregate notional < $400mm during the initial phase or < $150mm during subsequent phase; and SBS notional with special entities is less than $25mm DO NOT REGISTER as an SD. n.b. in each case, measure across affiliated entities, but exclude interaffiliates SBS.

• If no, YOU MUST REGISTER as an SBSD.


Who is required to register as a “major swap participant”?

Flow Chart of Major Swap Participant Determination

Overview

Section 721 of the Dodd-Frank Act defines an MSP as an entity that is not a

swap dealer and:

> maintains a “substantial position” in any of the major swap categories,

excluding positions used for “hedging or mitigating commercial risk,”

> has outstanding swaps that “create substantial counterparty exposure that

could have serious adverse effects on the financial stability of the United

States banking system or financial markets,” or

> is a “highly leveraged” financial entity that maintains a “substantial position”

in any major swap category.

These three tests seek to capture swap market participants whose activities

create the potential for systemic risk. The CFTC is authorized to flesh out and

set thresholds for a number of the terms used in the statutory definition, including

“substantial position,” “hedging or mitigating commercial risk,” “substantial

counterparty exposure,” “financial entity” and “highly leveraged.”

Thresholds for the first and third tests are established with reference to “major

swap categories,” which the CFTC has defined to include rates, credit, equity and

“other commodities.”

Substantial Position

The Final Rule sets forth two separate tests to define a “substantial position.”

Current Exposure Test

The first “substantial position test” calls for a market participant to mark to market

its swap positions to determine their current exposure and then deduct from that

amount the value of any collateral posted with respect to its swap positions55

and

any netting offsets available under the terms of any master netting agreements

with its counterparties. If the entity has an average uncollateralized exposure of

$3B or more in rates or $1B or more in any of the other swap categories over the

course of a fiscal quarter, it is an MSP.

55

As noted by the CFTC in its release, cleared swaps will largely be excluded from any analysis under the MSP definition that assesses uncollateralized exposure.

Do you have a substantial

position in a major swap category,

excluding hedging positions?

Do you have substantial

counterparty exposure as a

result of your swap positions?

Are you a highly leveraged financial

entity with a substantial

position in swaps?


Current Exposure and Potential Future Exposure Test

The second “substantial position” test is more complicated and considers both

current uncollateralized exposure and potential future exposure. Future exposure

is calculated by

> multiplying the total notional amount of an entity’s swap positions by a risk

factor discount percentage ranging from 0% to 15%;56

> discounting positions subject to master netting agreements by between 0%

and 60%,efficiency;57

and

> reducing the amount by another 80% if it is subject to daily mark-to-market

margining or 90% if it was cleared.

The thresholds established for the second test provide that a market participant is

an MSP if the sum of its average current uncollateralized swap exposure (as

calculated under the first test) and its potential future exposure is $6B or more in

the rates category or $2B or more in any other category.58

Hedging or Mitigating Commercial Risk

The first prong of the MSP definition seeks to capture market participants that

use swaps to speculate, not those that rely on swaps to hedge risk. Under that

56

The risk factor discounts are listed in a table contained in the rule. Final Rule § 1.xx(jjj)(3)(ii)(A)(1) tbl. 1. Generally, swaps with shorter maturities are considered less likely to result in future exposure, and thus have lower risk factor discounts. The table also lists different categories of swaps by asset class with progressively higher risk factor discounts generally applying to swaps in the following order: rates, foreign exchange and gold, other precious metals, equity, credit and other commodities.

57 The Final Rule sets forth a formula that market participants must use in order to calculate the discount for netting agreements. Final Rule § 1.xx(jjj)(3)(ii)(B). Under this provision, the notional amount multiplied by the risk factor discount is further reduced “by the ratio of net currency exposure to gross current exposure, consistent with the [provided] equation on a counterparty-by-counterparty basis.”

58 The calculation of potential future exposure may result in the double counting, to at least some extent, of an entity’s potential liability. If, for instance, an entity has $5 of exposure under a swap with a notional amount of $100, it makes little sense to use that notional amount as the basis for calculating the potential future exposure inasmuch as the calculation of current exposure has already caused that $5 of risk to be realized in the substantial position analysis.

Current Exposure Calculation

• Current Exposure = Mark-to-market value of swap positions minus (value of collateral posted + netting offsets + swap positions used to hedge commercial risk)

• If Current Exposure > $1B in any category of swaps (or $3B in rates), you are an MSP.

Potential Future Exposure Calculation

• Potential Future Exposure = (Gross notional amount of swap contracts minus notional amount of swap contracts used to hedge commercial risk) x Risk factor discount percentage x discount for netting agreements (if applicable) x [80% (if subject to daily mark-to-market) or 90% (if subject to clearing)].

• If Current Exposure (as calculated above) + Potential Future Exposure > $2B in any category of swaps (or $6B in rates), you are an MSP.


prong only, in calculating both current and future exposures, market participants

are allowed to exclude any swap positions that “hedg[e] or mitigat[e] commercial

risk.” The Final Rule defines that term to include swap positions that are not held

for trading or speculative purposes and that

> reduce commercial risk arising from the change in value of an entity’s

assets or liabilities, the change in value of services provided by an entity,

the change in value of inputs that the entity has acquired or reasonably

anticipates acquiring in the ordinary course of business, or the change in

interest, currency or foreign exchange rates associated with any of the

above,

> would qualify as a bona fide hedge under the position limits rule adopted

by the CFTC, or

> qualify as a hedging position under certain Financial Accounting Standards

Board and Government Accounting Standards Board rules.

The Final Rule also forbids a market participant from excluding from an exposure

calculation a swap position designed to hedge a separate speculative swap or

security-based swap position. Employee plans under the Employee Retirement

Income Security Act of 1974 (“ERISA”) are granted more flexibility in that they

may exclude swaps from their first prong analysis where the “primary purpose” of

the swap is to hedge, even if the plan is using the swap for speculative purposes

as well.

Substantial Counterparty Exposure

The second prong of the MSP definition captures market participants that have a

“substantial counterparty exposure” in swaps that could threaten U.S. financial

stability. Under this prong, a market participant must calculate its aggregate

current exposure and potential future exposure across major swap categories. In

conducting these calculations, the entity must include swap positions designed to

hedge, though it may continue to take into account the offsetting benefits of

collateral and netting agreements as discussed above. An entity will be

considered to have a substantial counterparty exposure and be an MSP if it has a

current uncollateralized current exposure of $5B across all major swap categories

or a sum of current uncollateralized current exposure and potential future

exposure of $8B across all major swap categories.


Highly Leveraged Financial Entities with a Substantial Position in

Swaps

The final category of entities that fall within the definition of MSP are financial

entities that (1) are “highly leveraged relative to the amount of capital” they hold,

(2) are not subject to U.S. bank capital rules, and (3) maintain a “substantial

position” in a major swap category (without the exclusion of hedging

transactions). The final rules borrow from the definition of “financial entity” used

in the end user exemption from Title VII’s clearing mandate, and dictate that

financial entities that may be considered an MSP under this prong include:

> SBSDs and MSBSPs;59

> commodity pools;

> private funds (as defined under the Investment Advisers Act of 1940);

> ERISA employee benefit plans; and

> entities primarily engaged in activities that are financial in nature under

Section 4(k) of the Bank Holding Company Act.

In its Proposed Rule, the CFTC sought comment on three possible liabilities-to-

equity ratios to define “highly leveraged,” ultimately rejecting the highest and

lowest proposal and settling on a ratio of 12-to-1 in the Final Rule.60

The Final

Rule directs market participants to calculate their balance sheet liabilities and

equity under U.S. generally accepted accounting principles (“GAAP”) to

determine whether they will be considered “highly leveraged.”61

Such a highly leveraged financial entity must also maintain a “substantial

position” in a major swap category to qualify as an MSP. The calculation of

59

As discussed in more detail below, the MSBSP definition is largely the same as the MSP definition. One obvious difference is that under the MSBSP definition, “financial entity” is defined to include SDs and MSPs rather than their security-based swap equivalents.

60 Final Rule at 338-340.

61 The commandment to calculate liabilities and equity under U.S. GAAP could prove problematic for some foreign market participants. There are some notable differences between U.S. GAAP and the International Financial Reporting Standards applicable in many other countries, particularly with respect to the netting treatment of derivative positions. While the CFTC may address the issue when it issues its much-anticipated rulemaking on extraterritoriality, it is possible that foreign market participants with a foothold in the U.S. market will find themselves assessing their balance sheet under both local accounting rules and under GAAP, which could be costly.

Substantial Counterparty Exposure Calculation

• Current Counterparty Exposure = Mark-to-market value of swap positions minus (value of collateral posted + netting offsets)

• Potential Future Counterparty Exposure = Gross notional amount of swap contracts x Risk factor discount percentage x discount for netting agreements (if applicable) x 80% (if subject to daily mark-to-market) or 90% (if subject to clearing).

• Both are calculated in the aggregate across all swap categories.

• If Current Counterparty Exposure > $5B across all swap categories or (Current Counterparty Exposure + Potential Future Counterparty Exposure) > $8B across all swap categories, you are an MSP.


“substantial position” is conducted in the same manner and with the same

thresholds as under the first prong of the definition, except that under this third

prong, the financial entity may not exclude swap positions used for hedging or

mitigating commercial risk from their exposure calculation.

Timing & Re-evaluation

Under the final rules, market participants must calculate their swap exposures on

a daily basis and determine whether their quarterly averages cause them to fall

within one of the three prongs of the MSP definition. The rules provide that an

entity will be deemed an MSP on the date it submits a complete MSP application

with the CFTC or two months after the end of the fiscal quarter in which it meets

the MSP criteria.

In order to prevent a transient increase in an entity’s swap positions to cause it to

have to register, the Final Rules allow entities that only narrowly exceed

applicable thresholds to “wait and see” whether they continue to qualify as an

MSP.62

Entities that only exceed the thresholds by 20% or less need not register

with the CFTC and will not be deemed an MSP automatically. Instead, the entity

will only be required to register if it exceeds one of the thresholds again in the

next quarter.63

Once an entity has registered as an MSP, it cannot withdraw its registration until

it falls below the applicable thresholds for four consecutive quarters.64

Safe Harbor

To limit the cost that market participants would incur by continuously evaluating

their swap exposure to determine whether they fit within the MSP definition, and

in response to public comments on the proposal, the Final Rules provide four

safe harbors that, if complied with, will allow an entity to avoid the burden of daily

swap exposure calculations. These safe harbors allow an entity such an

exemption if65

> the terms of the entity’s swap or security-based swap arrangements

prohibit it from accumulating more than $100mm in uncollateralized swap

exposure and its notional swap or security-based swap positions do not

exceed $2B in any single major swap category or $4B in the aggregate,

62

Final Rules § 1.3(hhh)(4). 63

Id. 64

Final Rules § 1.3(hhh)(5). 65

Final Rules § 1.3(hhh)(6).

Highly Leveraged Financial Entity Test Calculation

• If you are a "financial entity" and (liabilities / equity) > 12, you are a "highly leveraged financial entity."

• If you have a "substantial position" in swaps (under the test described above but taking into account swap positions used to hedge commercial risk), you are an MSP.


> the entity’s swap and security-based swap arrange terms prohibit more

than $200mm in uncollateralized swap exposure, the entity performs the

swap exposure calculations at the end of every month, and its calculations

indicate that it has exposures of no more than half of the current exposure

plus potential future exposure thresholds,

> the entity has current uncollateralized exposure of less than $500mm

($1.5B for rates) in each of the major swap categories, the entity conducts

modified exposure calculations at the end of every month, and the results

of those calculations indicate that its current exposure is less than half of

the relevant thresholds, or

> the entity has current uncollateralized exposure of less than $500mm

across all major swap categories and, in each swap category, the sum of

its uncollateralized exposure and 15% of the outstanding notional amount

of its positions is less than $1B.

The CFTC and the SEC emphasized that the mere fact that a market participant

does not qualify to invoke one of the safe harbors does not mean that it would be

presumed to be an MSP.66

Odds and Ends

The Final Rules and its supplementary material contain other important guidance

relevant to an entity’s analysis of whether it is an MSP. Among other things, the

agencies stated that

> an MSP may apply to limit its registration as an MSP to a single major

categories of swaps,

> in calculating an entity’s swap exposure, the entity may exclude swaps with

majority-owned affiliates,

> contrary to the Proposed Rule, a subsidiary’s swap or security-based swap

positions should not, as a matter of course, be attributed to its parents, but

instead parent attribution would generally only be allowed where the swap

counterparty had recourse to the parent,

> swap positions entered into by a managed account are not attributed to

either the asset manager or the beneficial owners of the account unless

counterparties have recourse to them, and

> foreign governments, foreign central banks and certain international

financial institutions are outside of the MSP definition.

66

Final Rules at 383.


Who is required to register a “major security-based swap

participant”?

Flow Chart of Major Security-Based Swap Participant Determination

Overview

The tests to determine whether an entity is an MSBSP largely mirror the structure

of the MSP definition. The primary differences between the two definitions are

numerical, and they are listed in the table below.

MSP Definition MSBSP Definition

Risk factor discounts

in calculating potential

future exposure

Range from 0% to 15% Range from 6% to 10%

Number of major

product categories

4 2

Thresholds for

“substantial position”

(first test)

$1B in any category ($3B

in rates)

$1B in either category

Thresholds for

“substantial position”

(second test)

$2B in any category ($6B

in rates)

$2B in either category

Threshold for

substantial

counterparty exposure

$5B in current

exposure/$8B in current

+ potential future

exposure

$2B in current

exposure/$4B in current

+ potential future

exposure

Modifications of and interpretative guidance in respect of the

Eligible Contract Participant definition

Overview

> SDs, SBSDs, MSPs and MSBSPs are included within the definition of ECPs

> Subject to the exception described below, commodity pools with non-ECP

Do you have a substantial

position in a major security-based swap category,

excluding hedging positions?

Do you have substantial

counterparty exposure as a result of your

security-based swap positions?

Are you a highly leveraged financial

entity with a substantial position in

security-based swaps?


investors will not be considered ECPs with respect to certain foreign

exchange transactions

> Commodity pools, the investors of which include other commodity pools with

non-ECP investors, retain their status of ECPs with respect to certain foreign

exchange transactions only to the extent that the pool structure is not

designed to evade Title VII

> Commodity pools advised by a commodity pool operator with assets of more

than $10m may participate in retail foreign exchange transactions even if they

have direct investors that are non-ECPs, provided that the pool was not

formed for the purpose of evading the prohibition on non-ECP involvement in

retail foreign exchange transactions

> Commodity pools advised by a non-U.S. commodity pool advisor and the

participants in which are all non-U.S. persons are ECPs for purposes of

foreign exchange transactions

> Entities that use swaps to hedge commercial risk may include the net worth

of their owners in determining whether they qualify as ECPs provided that all

of those owners are themselves ECPs

In addition to further defining the contours of the new classes of registrants

created by Title VII, the Final Rule alters the definition of “eligible contract

participant” (“ECP”), both to update it to reflect the new registrants and to

accommodate and provide guidance concerning certain alterations to the ECP

definition made by Title VII. Among other things, only an ECP is eligible to:

> enter into a swap or SBS off of a designated contract market or a national

securities exchange;

> trade on a swap execution facility or a security-based swap execution

facility; and

> offer to sell, offer to buy, sell or purchase a security-based swap unless it is

registered under the Securities Act of 1933, as amended.

First and foremost, the Final Rule alters the ECP definition to include SDs,

SBSDs, MSPs and MSBSPs. As described more fully below, it also implements

a “look through” used to determine whether commodity pools qualify as ECPs

with respect to certain retail foreign exchange transactions (“Retail Forex

Transactions”),67

and it creates an exception from the “look through” for certain

large commodity pools advised by a commodity pool advisor. The Final Rule

also establishes a look through for entities that use swaps to hedge their

67

According to the CFTC, Retail Forex Transactions include off-exchange foreign currency futures, off-exchange options on foreign currency futures, off-exchange options on foreign currency, leveraged or margined foreign currency transactions, and foreign currency transactions that are financed by the offeror, the counterparty or a person acting in concert with either of them.


commercial risk that allows them to include their owners’ net worth when

determining their own under certain circumstances.

Forex Pools

Title VII modified the statutory definition of ECP by, among other things, deeming

that commodity pools with non-ECP participants are not themselves ECPs with

respect to Retail Forex Transactions.68

A separate prong (the “Net Worth

Business Provision”) of the statutory ECP definition includes corporations or

other business entities with a net worth exceeding $1mm. Under the Proposed

Rule, in order for a commodity pool to be considered an ECP with respect to

Retail Forex Transactions (such a pool, a “Retail Forex-Qualified Pool”), not

only would all of its own participants (“Direct Participants”) need to be ECPs,

but investors in other commodity pools that invested in the pool in question (such

investors, “Indirect Participants”) would themselves have to be ECPs,

notwithstanding the Net Worth Business Provision. In other words, “if there was

any non-ECP participant at any level of the pool structure (e.g., the pool itself, a

direct participant that invests in the pool, or any indirect participant that invests in

that pool throughout pools or vehicles),” the pool would not be a Retail Forex-

Qualified Pool.

This approach was the subject of significant criticism during the public comment

process. In response to that criticism, the SEC and the CFTC have adjusted the

Final Rule to employ an “evasion-based look-through” approach. Commodity

pools with non-ECP Direct Participants are not Retail Forex-Qualified Pools,

subject to the exception discussed below. However, those with non-ECP Indirect

Participants may be Retail Forex-Qualified Pools unless the pool structure is

designed to evade Subtitle A of Title VII. Thus, the mere presence of a non-ECP

somewhere in the pool structure will not necessarily prevent a commodity pool

from being a Retail Forex-Qualified Pool.

The Final Rule’s supplementary material states that the agencies would consider

it an evasion “if a commodity pool tier has been included in the structure . . .

primarily to provide non-ECP participants exposure to Retail Forex Transactions

rather than to achieve any other legitimate business purpose.” As an example of

such a “legitimate business purpose,” the agencies indicate that Retail Forex

Transactions could be used to hedge currency risk associated with fund-of-fund

investments in foreign-denominated funds. Where, however, the aim is

“exposure to Retail Forex Transactions as an asset class, investment strategy, or

an end in itself,” the commodity pool in question would not be a Retail Forex-

Qualified Pool.

One important carve out to is provided with respect to offshore commodity pools.

Under the Final Rules, commodity pools advised by a non-U.S. commodity pool

68

The lack of ECP status for such a commodity pool would not prevent it from engaging in Retail Forex Transactions with certain counterparties, including banks, broker-dealers, FCMs and others.


operator qualify as ECPs provided that all of their participants are non-U.S.

persons, regardless of the participants’ ECP status of the participants.69

Commodity Pools Deemed to be Retail Forex-Qualified Pools

In response to public comments, the CFTC also adopted a new regulation to

allow commodity pools with non-ECP participants to qualify as an ECP if:

> it was not “formed for the purpose” of evading regulation under Commodity

Exchange Act provisions governing Retail Forex Transactions;

> it has total assets of more than $10m; and

> it was formed and is operated by a registered commodity pool operator or

a commodity pool operator that is exempt from registration as such.70

The CFTC did not provide guidance on what might constitute evasion under the

new regulation. Its anti-evasion provision differs somewhat from the anti-evasion

provision discussed above in that the former references the Retail Forex

Transactions provision of the Commodity Exchange Act expressly whereas the

latter merely references Subtitle A. That said, it seems likely that the agency

guidance discussed above is probably applicable to the new regulation, and any

commodity pool structure that allowed non-ECP participants to access

speculative Retail Forex Transaction positions would be found to violate the

CFTC’s new regulation.

Look Through for Line of Business Hedging

In addition to the look through described above, the Final Rules establish an

additional look through for entities that use swaps to hedge commercial risk.

Under this look through, an entity may include the net worth of its owners when

calculating its own net worth for purposes of determining the applicability of the

Net Worth Business Provision if every owner is an ECP and the swaps are

employed only to hedge commercial risk. For purposes of this allowance, the

Final Rules would look through to the owners of both the entity seeking to hedge

and any shell companies that own that entity. This exception does not apply with

respect to SBS.

69

For purposes of this carve out, the CFTC refers to the definition of “Non-United States person” contained in CFTC Regulation 4.7(a)(1)(iv). It also indicates a that an entity “organized principally for passive investment” will be considered a non-U.S. person for purposes of the carve out if all of the its investors are themselves “Non-United States persons.”

70 Final Rules at 245.


Authors: Individuals listed as Contacts.

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Extraterritoriality

The Final Rule Release does not address the myriad array of extraterritorial

issues raised by the Final Rule and other CFTC and SEC rulemakings directly

and indirectly related to the Final Rule Release. However, the Final Rule

Release does state, “The Commissions intend to separately address issues

related to the application of these definitions to non-U.S. persons in the context

of the application of Title VII to non-U.S. persons.”71

While this is very little to go

on, it may suggest that the Commissions are moving towards a U.S. person/non-

U.S. person based approach rather than the sort of relationship gradient test

that many had feared. Of course, the language could just be colloquial and we

will not know for sure until we see some rule proposals on extraterritoriality.

Effective Dates

The Final Rule and the Interim Final Rule will be effective 60 days following

publication in the Federal Register, provided that the effective date for CFTC

Regulations §§1.3(m)(5) and 1.3(m)(6) is December 31, 2012.

Persons deemed to be SBSDs or MSBSPs are not required to register until the

dates to be specified in the SEC’s final rules regarding SBSD and MSBSP

registration requirements.72

For persons deemed to be SDs or MSPs, provisional

registration is permitted any time prior to the latest effective date of the final

rules defining the terms “swap”, “swap dealer” and “major swap participant” and

is required by the latest effective date of those final rules.

71



Documents

CFTC and SEC Finalize a Key Piece of the Dodd-Frank Act ... · Act Registration Requirements Puzzle with the Final Entity Definitions Rules, but Many Pieces of the Puzzle Remain Missing