United States: The CFTC’s Rule For Reviewing Swaps For Mandatory Clearing Reveals The Complexity Of Making These Determinations

On July 26, 2011, the Commodity Futures Trading Commission ("CFTC") unanimously adopted 17 CFR 39.5 – "Review of swaps for Commission determination on clearing requirements" which will become effective on September 26, 2011.

CFTC acknowledgement of swap complexity. Derivatives are notoriously complex, embedded in widely diverse industries and serve a dizzying array of purposes. This particular regulation is fascinating for a number of reasons, including the window it provides into the CFTC's efforts to standardize and regulate swaps, only one type of derivative. The exceptionally open-ended nature of the regulation essentially acknowledges that the CFTC has no idea today how it will handle the various transactions that will be captured by the broad definitions of "derivative" and "swap" that regulators are developing under Dodd-Frank.

Purpose of the regulation. Section 723(a)(3) of Dodd-Frank Act says "it shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization (DCO) that is registered . . . or exempt from registration . . . if the swap is required to be cleared." That section of Dodd-Frank also directs the CFTC to adopt rules for the review of a swap or category of swaps for the purpose of determining whether the swaps must be cleared. Section 745(b) of Dodd-Frank requires the Commission to prescribe rules under which the CFTC will determine the initial eligibility or continuing qualification of a DCO to clear swaps. Accordingly, the CFTC's purpose for this particular regulation is to establish procedures for:

What is a derivatives clearing organization? As background, a derivatives clearing organization (DCO) is a clearinghouse, clearing association, clearing corporation or similar entity that enables each party to an agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants. There are currently 22 DCOs registered with the CFTC, including the largest DCO, Options Clearing Corporation, and specialty CDOs like Natural Gas Exchange, Inc., a Canadian firm that trades and clears primarily spot and forward physically-settled contracts in natural gas, electricity, and other energy sources in North America.

The CFTC regulates "swaps" (see full statutory definition at the end of this article) and the SEC regulates security-based swaps. The CFTC and the SEC, in consultation with the Federal Reserve, will have joint rule-making authority over mixed swaps. The CFTC has proposed the following definition of a CFTC-regulated "swap" although the definition regulation is not yet final (the portion dealing with foreign exchange swaps and forwards is omitted):

§240.3a69–2 Definition of "swap" as used in section 3(a)(69) of the Act—Additional Products.

(a) In general. The term swap has the meaning set forth in section 3(a)(69) of the Act (15 U.S.C. 78c(a)(69)).

(b) Inclusion of particular products.

(1) The term swap includes, without limiting the meaning set forth in section 3(a)(69) of the Act (15 U.S.C. 78c(a)(69), the following agreements, contracts, and transactions:

(i) cross-currency swap;

(ii) A currency option, foreign currency option, foreign exchange option and foreign exchange rate option;

(iii) A foreign exchange forward;

(iv) A foreign exchange swap;

(v) A forward rate agreement; and

(vi) A non-deliverable forward involving foreign exchange.

(2) The term swap does not include an agreement, contract, or transaction described in paragraph (b)(1) of this section that is otherwise excluded by section 1a(47)(B) of the Commodity Exchange Act (7 U.S.C. 1a(47)(B)).

Eligibility to clear swaps. The CFTC presumes (subject to review) that a DCO is eligible to accept for clearing any swap that is within a group, category, type, or class of swaps that the DCO already clears. If a DCO wants to clear a new type of swap that it doesn't already clear, then the DCO must request eligibility to clear determination from the CFTC before accepting the swap for clearing. The request, which must be filed electronically with the CFTC, must address the DCO's ability to maintain legal compliance, in particular:

1. The sufficiency of the DCO's financial resources; and DCO will be able to maintain compliance with section 5b(c)(2) of the Act;
2. The derivative clearing organization's ability to manage the risks associated with clearing the swap, especially if the CFTC determines that the swap is required to be cleared.

Swap submissions. Each eligible DCO must submit to the CFTC each new type or class of swaps that it plans to accept for clearing. These requirements apply to the submission:

• Submit swaps, to the extent reasonable and practicable to do so, by group, category, type, or class of swaps. The CFTC may in its reasonable discretion consolidate multiple submissions from one DCO or subdivide a DCO's submission as appropriate for review.
• The submission must be filed electronically and must include:
• • A statement that the DCO is eligible to accept the swap, or group, category, type, or class of swaps for clearing and describes the extent to which, if the CFTC were to determine that the swap, or group, category, type, or class of swaps is required to be cleared, the DCO will be able to maintain compliance with section 5b(c)(2) of the Act;
  • A statement that includes, but is not limited to, information that will assist the CFTC in making a quantitative and qualitative assessment of the following factors:

• The submission will be made available to the public and posted on the CFTC.gov for a 30-day public comment period. But, a DCO can request confidential treatment of portions of its submission. The CFTC may extend the comment period on a case-by-case basis. Allowing public input on each category of swap is an unusual step, but the CFTC felt it was consistent with Congressional intent. It is also wise, given the complexity and widely varying purposes of what will be deemed swaps. By involving the public, the CFTC can avoid blame for creating regulations in a vacuum. Accordingly, market participants should closely monitor all such submissions.
• The CFTC will review the submission and determine, within 90 days, whether the swap, or group, category, type, or class of swaps described in the submission is required to be cleared. The CFTC decides in its sole discretion when a submission is complete. If the CFTC determines that clearing requirements apply, the CFTC will impose such terms and conditions to the clearing requirement as it thinks appropriate.

CFTC-initiated reviews. The CFTC, on an ongoing basis, will review swaps that have not been accepted for clearing by a DCO to make a determination as to whether the swaps should be required to be cleared. In undertaking such reviews, the CFTC will use information obtained pursuant to CFTC regulations from swap data repositories, swap dealers, and major swap participants, and any other available information. The CFTC will post a notice of its determinations on the CFTC Web site for a 30-day public comment period.

If no DCO has accepted for clearing a particular swap, group, category, type, or class of swaps that the CFTC finds would otherwise be subject to a clearing requirement, the CFTC will:

1. Investigate the relevant facts and circumstances;
2. Within 30 days of the completion of its investigation, issue a public report containing the results of the investigation; and
3. Take such actions as it determines to be necessary and in the public interest, which may include requiring the retaining of adequate margin or capital by parties to the swap, group, category, type, or class of swaps.

4. Stay of clearing requirement. After making a determination that a swap, or group, category, type, or class of swaps is required to be cleared, the CFTC, on application of a counterparty to a swap or on its own initiative, may stay the clearing requirement until the CFTC completes a review of the terms of the swap, or group, category, type, or class of swaps and the clearing arrangement. Any application for a stay of the clearing requirement must include:

1. The identity and contact information of the counterparty to the swap;
2. The terms of the swap subject to the clearing requirement;
3. The name of the DCO clearing the swap;
4. A description of the clearing arrangement; and
5. A statement explaining why the swap should not be subject to a clearing requirement.

6. A DCO that has accepted for clearing a swap, or group, category, type, or class of swaps that is subject to a stay of the clearing requirement must provide any information requested by the CFTC in the course of its review.

   The CFTC will complete its review not later than 90 days after issuance of the stay, unless the DCO that clears the swap, or group, category, type, or class of swaps agrees to an extension.

   Upon completion of its review, the CFTC may:

1. Determine, subject to any terms and conditions as the CFTC determines to be appropriate, that the swap, or group, category, type, or class of swaps must be cleared; or
2. Determine that the clearing requirement will not apply to the swap, or group, category, type, or class of swaps, but clearing may continue on a non-mandatory basis.

What is a swap? The products that are covered by Title VII of Dodd-Frank are divided into two main categories: swaps and security- based swaps. A third category, "mixed swaps", covers products that have both swap and security-based swap characteristics. Section 711 of Dodd-Frank cross-references the Commodity Exchange Act (7 U.S.C. 1a) for the definition of swap and Section 721(a)(21) of Dodd-Frank amends the Commodity Exchange Act by adding the following definition of "swap":

(47) SWAP.—

(A) IN GENERAL.—Except as provided in subparagraph (B), the term "swap" means any agreement, contract, or transaction—

(i) that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind;

(ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence;

(iii) that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred, including any agreement, contract, or transaction commonly known as—

(iv) that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap;

(v) including any security-based swap agreement which meets the definition of 'swap agreement' as defined in section 206A of the Gramm-Leach-Bliley Act (15 U.S.C. 78c note) of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein; or

(vi) that is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (v).

(B) EXCLUSIONS.—The term "swap" does not include—

(i) any contract of sale of a commodity for future delivery (or option on such a contract), leverage contract authorized under section 19, security futures product, or agreement, contract, or transaction described in section 2(c)(2)(C)(i) or section 2(c)(2)(D)(i);

(ii) any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled;

(iii) any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof, that is subject to—

(I) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and

(II) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);

(iv) any put, call, straddle, option, or privilege relating to a foreign currency entered into on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a));

(v) any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to—

(I) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and

(II) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);

(vi) any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a contingent basis that is subject to the Securities Act of 1933 (15 U.S.C. 77a et seq.) and the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), unless the agreement, contract, or transaction predicates the purchase or sale on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a party other than a party to the agreement, contract, or transaction;

(vii) any note, bond, or evidence of indebtedness that is a security, as defined in section 2(a)(1) of the Securities Act of 1933 (15 U.S.C. 77b(a)(1));

(viii) any agreement, contract, or transaction that is—

(I) based on a security; and

(II) entered into directly or through an underwriter (as defined in section 2(a)(11) of the Securities Act of 1933 (15 U.S.C. 77b(a)(11)) by the issuer of such security for the purposes of raising capital, unless the agreement, contract, or transaction is entered into to manage a risk associated with capital raising;

(ix) any agreement, contract, or transaction a counterparty of which is a Federal Reserve bank, the Federal Government, or a Federal agency that is expressly backed by the full faith and credit of the United States; and

(x) any security-based swap, other than a security- based swap as described in subparagraph (D).

Daniel Wheeler is a banking regulatory partner in the Buchalter Nemer law firm.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.