The SEC and the Commodity Futures Trading Commission (CFTC) (together, the Commissions) have jointly issued a rule proposal (Proposed Rules) to define terms related to the swap and security-based swap markets as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd- Frank Act). The Proposed Rules offer definitions of the terms "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant," and "eligible contract participant." This article's focus is on the proposed definitions of "major swap participant" and "major security-based swap participant" (the Proposed Definitions).

The Dodd-Frank Act added the terms "major swap participant" and "major security-based swap participant" (collectively Major Participant) to the Commodity Exchange Act, as amended (the Commodity Act), and the Securities Exchange Act of 1934, as amended (the Exchange Act), respectively, to regulate entities with large swap positions that do not qualify as swap dealers or security-based swap dealers, but could still have a significant impact on the financial markets. The Proposed Definitions could have a major effect on registered investment companies, private investment funds and their advisers and commodity pool operators that do not fall within the definition of a swap/ security-based swap dealer but yet still may qualify as Major Participants. The Dodd-Frank Act requires all entities deemed Major Participants to register as such and subjects those entities to additional capital, margin and business conduct requirements.

The Dodd-Frank Act sets out three alternatives for identifying a Major Participant. It defines a Major Participant as:

  • A person that maintains a "substantial position" in any of the major swap categories, excluding positions held for "hedging or mitigating commercial risk" and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan (alternative 1);
  • A person whose outstanding swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets" (alternative 2); or
  • Any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a "substantial position" in any of the major swap categories (alternative 3).

Mandated by Congress, the Commissions seek to further define Major Participants by addressing (a) the major categories of swaps or securities-based swaps, (b) the meaning of "substantial position," (c) the meaning of "hedging or mitigating commercial risk," (d) the meaning of "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets," and (e) the meanings of "financial entity" and "highly leveraged."

Major Categories of Swaps and Securities-Based Swaps

The Commissions propose to limit an entity's designation as a Major Participant to only certain types, classes or categories of swaps or security-based swaps. An entity may be deemed a Major Participant for one category of swaps or security-based swaps but not for another. The major categories will apply only for purposes of the Major Participant definitions and are not necessarily determinative with respect to any other provision of the Dodd-Frank Act.

The Commissions propose to designate four categories of swaps for purposes of the "major swap participant" definition: rate swaps, credit swaps, equity swaps and other commodity swaps. The four major categories of swaps are intended to cover all swaps. The first category would encompass any swap that is primarily based on reference rates, such as swaps of payments determined by fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates. The second category would encompass any swap that is primarily based on instruments of indebtedness, including but not limited to any swap primarily based on one or more indices related to debt instruments, or any swap that is an index credit default swap or total return swap on one or more indices of debt instruments. The third category would encompass any swap that is primarily based on equity securities, such as any swap primarily based on one or more indices of equity securities, or any total return swap on one or more equity indices. The fourth category would encompass any swap not included in any of the first three categories. Each swap would be in the category that most closely describes the primary item underlying the swap. If a swap is based on more than one underlying item of different types, the swap would be in the category that describes the underlying item that is likely to have the most significant effect on the economic return of the swap.

The Commissions propose to designate two categories of security-based swaps for purposes of the "major security-based swap" definition. The first category would encompass any security-based swap that is based on instruments of indebtedness, or a credit event relating to issuers or securities. The second category would encompass any other security-based swaps not included in the first category.

"Substantial Position"

The Commissions are proposing two tests to define "substantial position" in alternative one of the "Major Participant" definition. One test would focus exclusively on an entity's current uncollateralized exposure; the other would supplement a current uncollateralized exposure measure with an additional measure that estimates potential future exposure. A position that satisfies either test would be a "substantial position."

Current Uncollateralized Exposure Test

The current uncollateralized exposure test would set the substantial position threshold by reference to the sum of the uncollateralized current exposure, obtained by marking-to-market using industry standard practices and arising from each of an entity's positions with negative value in each of the applicable major categories of swaps or security-based swaps. This proposed test would account for the risk-mitigating effects of netting agreements by permitting an entity to calculate its exposure on a net basis, by applying the terms of master netting agreements entered into between the entity and a single counterparty. When calculating the net exposure the entity may take into account offsetting positions with that particular counterparty involving swaps, security-based swaps and securities financing transactions to the extent that is consistent with the offsets provided by the master netting agreement. This measurement would be calculated as a daily average measured at the close of each business day in a calendar quarter. The Commissions set the uncollateralized exposure threshold for a "major swap participant" at a daily average of $1 billion for credit, equity, or other commodity swaps, and $3 billion for rate swaps. The threshold for a "major security-based swap participant" would be $1 billion for each of the two defined categories.

Current Uncollateralized Exposure Plus Potential Future Exposure Test

The second substantial position test takes into account the aggregate of current uncollateralized exposure and the potential future exposure within a particular category of swaps. Under this test, the potential future exposure is calculated by multiplying the total notional principal amount of the entity's swap positions by specified risk factor percentages and then discounting that number to account for master netting agreements, cleared swaps and swaps subject to daily mark-to-market margining. Under this test, the Commissions set the exposure threshold for a "major swap participant" at a daily average exposure of $2 billion for credit, equity, or other commodity swaps, and $6 billion for rate swaps. The exposure threshold for a "major security-based swap participant" would be $2 billion for each of the two defined categories.

Hedging or Mitigating Commercial Risk

The first alternative of the Major Participant definition excludes positions held for "hedging or mitigating commercial risk" from the substantial position analysis. The Commissions have proposed that the following types of swap positions be excluded from the substantial positions analysis:

  • Swaps that qualify as bona fide hedges under existing Commodity Act regulations;
  • Swaps that qualify for hedging treatment under Financial Accounting Standards Board Statement No. 133; or
  • A swap position that is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from:
    • A potential change in the value of (1) assets that a person owns, produces, manufactures, processes, or merchandises, (2) liabilities that a person incurs, or (3) services that a person provides or purchases;
    • A potential change in value related to any of the foregoing arising from foreign exchange rate movements; or
    • A fluctuation in interest, currency, or foreign exchange rate exposures arising from a person's assets or liabilities.

Substantial Counterparty Exposure Test

The second alternative of the Major Participant definition seeks to measure substantial counterparty exposure, rather than a substantial position. The Commissions propose to rely on the same tests utilized to determine a substantial position, with a few significant differences. As proposed, the substantial counterparty exposure test will measure across all swap categories and will not exclude hedging or employee benefit plan positions. The exposure thresholds under this test are significantly higher than either of the substantial position tests. If an entity, in the aggregate, maintains uncollateralized swap exposure of a daily average of $5 billion or uncollateralized swap exposure plus potential future exposure of $8 billion, that entity will qualify as a Major Participant.

"Financial Entity" and "Highly Leveraged"

The third alternative of the Major Participant definition addresses any "financial entity," other than one subject to capital requirements established by an appropriate federal banking agency, that is "highly leveraged relative to the amount of capital" the entity holds, and that maintains a substantial position in a major category of swaps or security-based swaps. This test does not permit an exclusion for positions held for hedging.

"Financial Entity"

The Commissions propose to utilize the definition of financial entity from Section 2(h)(7) of the Commodity Act and Section 3C(g)(3) of the Exchange Act, respectively, as amended by the Dodd-Frank Act. As such, the statutory definition of a financial entity would be a swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, commodity pool, private fund, employee benefit plan, or person predominately engaged in the activities that are the business of banking (a Financial Entity).

"Highly Leveraged"

The Commissions propose two possible definitions of the point at which a Financial Entity would be "highly leveraged" – either a Financial Entity would be "highly leveraged" if the ratio of its total liabilities to equity is in excess of 8 to 1, or a Financial Entity would be "highly leveraged" if the ratio of its total liabilities to equity is in excess of 15 to 1. In either case, the determination would be measured at the close of business on the last business day of the applicable fiscal quarter. To promote consistent application of this leverage test, Financial Entities that file quarterly reports on Form 10-Q and annual reports on Form 10-K with the SEC would determine their total liabilities and equity based on the financial statements included with such filings. All other Financial Entities would calculate the value of total liabilities and equity consistent with the proper application of U.S. generally accepted accounting principles. The Commissions solicited comments as to whether this ratio should be set at 8 to1 or 15 to 1.

Full copies of the Proposed Rules can be found at http://www.sec.gov/rules/proposed/2010/34-63452.pdf and http://www.gpo.gov/fdsys/pkg/FR-2010-12-21/pdf/2010-31130.pdf.

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